Covered Bond

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21 Aug, 2024

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A covered bond is a debt security issued by a bank or other lending institution, typically backed by a specific pool of high-quality assets, such as residential or commercial mortgages. The primary purpose of it is to provide an additional funding source to the issuing institution while offering investors a low-risk investment option.

The distinguishing feature of this type of bond is that they offer bondholders a dual recourse: they have a claim on the issuer's creditworthiness and the assets that back the bond. It means that in the event of default by the issuer, bondholders have priority over other unsecured creditors in accessing the assets that back the bond.

What is a Covered Bond?

Covered bonds are debt security issued by banks and other lending institutions, typically backed by a specific pool of high-quality assets, such as residential or commercial mortgages.
Its main purpose is to provide lending institutions with an additional funding source while offering investors low-risk investment options.
They are generally considered safer and less volatile than other debt securities, as they are backed by a pool of high-quality assets and benefit from a dual recourse structure.

Covered Bond Explained

The issuance of covered bonds provides banks with an additional funding source, which they can use to finance their lending activities. In addition, covered bonds are attractive to investors because of their relatively low risk compared to other types of debt securities due to the collateralization of the bond with high-quality assets. As a result, covered bonds typically offer lower yields than other debt securities.

The assets that back the bond are held in a separate legal entity known as a cover pool. The cover pool is typically ring-fenced from the issuer's other assets and is subject to specific legal and regulatory requirements, such as diversification and quality criteria. The assets in the cover pool are also subject to ongoing monitoring and reporting requirements to ensure they continue to meet these criteria.

In the event of default by the issuer, the assets in the cover pool are used to repay bondholders up to the amount of their investment. If there is any shortfall, the bondholders have a claim on the issuer's remaining assets. This dual recourse structure provides investors an additional layer of protection compared to other debt securities, making covered bonds an attractive investment for risk-averse investors.

Examples

Let us look at some examples to understand the concept better:

Example #1

The Australian Government passed legislation permitting covered bonds to be issued in 2011, marking the beginning of the Australian covered bond market. Since then, there has been a major increase in the number of covered bonds issued, which in 2017 accounted for about 15% of the total long-term debt of Australian financial institutions. Furthermore, the Australian covered bond market has nearly reached asset-backed securities market size, with approximately $80 billion in outstanding bonds.

Example #2

Using scientifically supported environmental taxonomy, the UN Sustainable Development Goals, and a more granular score out of 100, Sustainable Fitch assigns each bond an ESG rating on a scale from 1-5.

To provide investors with a benchmark by which they can assess structured bonds that make social claims, Sustainable Fitch has introduced an ESG grading methodology for ABS and covered bonds that will initially encompass more than USD100 billion of labeled securities globally. The rating for ABS and covered bonds is determined by looking at the underlying assets, the usage of the proceeds, and the green bond or social bond framework.

Benefits

There are several benefits, including:

Lower Risk: They are typically considered lower risk than other debt securities because a specific pool of high-quality assets, such as residential mortgages or commercial mortgages, backs them. It means that in the event of default by the issuer, bondholders have priority over other unsecured creditors in accessing the assets that back the bond.

Additional Source of Funding: They provide additional funding to lending institutions, typically banks, which they can use to finance their lending activities. This can be especially important during economic stress, when access to funding may be more difficult.

Dual Recourse: As mentioned earlier, these bonds offer bondholders a dual recourse, which means they have a claim on the issuer's creditworthiness and the assets that back the bond. This provides additional protection to investors, making it an attractive investment for risk-averse investors.

Liquidity: They are generally considered more liquid than other debt securities, making them easier to buy and sell in the secondary market.

Regulatory Framework: They are subject to specific legal and regulatory requirements, such as diversification and quality criteria, which can help ensure that the cover pool assets are of high quality and that the risk associated with the bond is well-managed.

They offer several benefits to issuing institutions and investors, including lower risk, additional funding, dual recourse, liquidity, and a strong regulatory framework.

Covered Bond vs Asset-Backed Securities vs Securitization

Feature	Covered Bond	Asset-Backed Securities (ABS)	Securitization
Issuer	Lending institutions such as banks.	Any institution, including banks, corporations, and governments.	Any institution, including banks, corporations, and governments.
Asset Pool	A specific pool of high-quality assets, such as mortgages.	A pool of financial assets such as loans, leases, or receivables.	A pool of financial assets such as loans, leases, or receivables.
Risk	Lower risk due to dual recourse and strong regulatory framework.	Typically higher risk due to non-specific asset pools and reliance on credit ratings.	Varies depending on the quality of the underlying assets.
Collateral	The assets in the cover pool back the bond	The assets in the pool back the securities	The assets in the pool back the securities
Trading	Generally more liquid than ABS due to the dual recourse.	Trading can be more difficult due to lower liquidity.	Trading can be more difficult due to lower liquidity.
Purpose	To provide an additional source of funding for the issuer while offering low-risk investments to investors.	To allow issuers to obtain funding by selling off the cash flows from a pool of assets.	To allow issuers to obtain funding by selling off the cash flows from a pool of assets.

Frequently Asked Questions (FAQs)

What are the disadvantages of a covered bond?

Covered bonds come with a few potential disadvantages to consider. One of the main drawbacks is that they are backed by a specific pool of high-quality assets, such as mortgages, which limits the size of the asset pool. As a result, it can make it more difficult for lenders to raise large amounts of funding.

What are the types of covered bonds?

There are two main types: soft bullet and hard bullet. Soft bullet-covered bonds have a final maturity date. Still, the issuer can extend the maturity date if the assets in the cover pool remain sufficient to cover the bond's outstanding principal and interest payments. In contrast, hard bullet-covered bonds have a fixed maturity date, and the issuer must redeem the bond at the end of its term.

What is a retained covered bond?

A retained covered bond, also known as a balance sheet-driven covered bond, is issued by a bank or other financial institution and then held on its balance sheet rather than sold to investors in the open market.