Covered bonds

Covered Bonds

A covered bond is a type of debt instrument issued by financial institutions, typically banks, that is backed by a segregated pool of assets, most commonly mortgage loans or public sector loans. These secured debt instruments offer investors a dual layer of protection: a claim against the issuing institution itself and a preferential claim on the designated pool of underlying assets, known as the "cover pool." This "dual recourse" mechanism enhances the safety and credit quality of covered bonds, making them a significant component within the broader category of debt instruments.,²⁵,²⁴

History and Origin

The concept of covered bonds dates back centuries, with their origins often traced to 18th-century Prussia. In 1769, King Frederick the Great introduced the "Silesian Landschaft model," which laid the legal groundwork for the German Pfandbrief, considered the first modern covered bond. This innovation provided a mechanism for landowners to access long-term capital by combining mortgages on property with bonds, facilitating community-wide projects.²³

The model proved robust, especially in times of crisis, spreading across Europe. For instance, in Denmark in 1797, covered bonds known as Realkreditobligationer were issued to finance the rebuilding of Copenhagen after a major fire. France followed suit in 1852 with Obligations Foncières. This long history has established covered bonds as a stable and safe financing tool, particularly in European capital markets, where they have been a staple for financing real estate and public sector entities.
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Key Takeaways

• Covered bonds are debt instruments issued by banks and secured by a pool of high-quality assets, primarily mortgages or public sector loans.,
  ²¹* They provide "dual recourse" to investors: a claim against the issuing financial institution and a preferential claim on the dedicated cover pool.
• The cover pool remains on the issuer's balance sheet but is ring-fenced, meaning it is protected from the issuer's general creditors in the event of insolvency.
• Covered bonds generally carry higher credit ratings and lower yields compared to unsecured bonds due to their enhanced security features.
  ²⁰* They serve as a stable, long-term funding source for financial institutions and are a common feature in many European economies.
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Interpreting Covered Bonds

Understanding covered bonds involves recognizing their unique structure and the layers of protection they offer. When evaluating a covered bond, investors consider not only the creditworthiness of the issuing bank but also the quality and composition of the underlying collateral pool. This dual recourse mechanism significantly reduces credit risk for bondholders.

The cover pool is dynamically managed, meaning non-performing or prepaid loans within the pool must be replaced with new, high-quality assets to maintain the required level of overcollateralization—where the value of the collateral exceeds the principal amount of the bonds outstanding. This active management helps ensure the ongoing security of the covered bonds. The Federal Reserve Bank of San Francisco notes that covered bonds, due to their robust structure, are generally viewed as a stable and attractive investment for those seeking lower risk.

#¹⁸# Hypothetical Example

Imagine "EuroBank," a hypothetical financial institution, wants to raise capital to fund new mortgage lending. Instead of issuing unsecured debt, EuroBank decides to issue covered bonds.

1. Creation of Cover Pool: EuroBank designates a pool of €500 million worth of high-quality, performing residential mortgage loans from its balance sheet to serve as collateral for the new bonds. This "cover pool" is legally segregated but remains on EuroBank's books.
2. Issuance of Covered Bonds: EuroBank then issues €450 million in covered bonds to investors. This means the bonds are "overcollateralized" by €50 million (the difference between the €500 million cover pool and €450 million bonds), providing an additional safety buffer.
3. Investor Protection: Investors who purchase these covered bonds receive regular interest payments from EuroBank. If EuroBank were to face financial distress or even bankruptcy, bondholders would first have a claim on the €500 million mortgage pool. If the assets in this pool were insufficient to cover their claims, they would then have a recourse against EuroBank's remaining general assets, similar to other senior creditors. This dual protection makes the covered bonds appealing to conservative bondholders.

Practical Applications

Covered bonds are a vital tool for issuers, investors, and financial regulators across global markets.

• Bank Funding: For banks, covered bonds offer a stable and cost-effective source of long-term funding, particularly for mortgage lending and public sector financing. They can diversify a bank's funding mix and extend the maturity profile of its liabilities, reducing reliance on short-term wholesale funding.
• Investor¹⁷ Portfolios: For investors, especially institutional investors like pension funds and insurance companies, covered bonds provide a highly-rated, low-risk fixed income investment option. Their dual recourse and robust regulatory framework contribute to their appeal as a safe asset, often receiving high credit ratings.
• Financia¹⁶l Stability: Regulators often view covered bonds favorably because their transparency and inherent security features can contribute to financial stability. The European Banking Authority (EBA) plays a significant role in harmonizing regulatory standards for covered bonds across the European Union, enhancing their reliability and cross-border appeal., This regulato¹⁵r¹⁴y oversight helps ensure that the instruments maintain their high quality.
• Central Bank Operations: In times of market stress, central banks, such as the European Central Bank (ECB), have used covered bond purchase programs to support market liquidity and facilitate lending to financial institutions, highlighting their strategic importance in monetary policy.

Limitation¹³s and Criticisms

Despite their reputation for safety, covered bonds are not without limitations and potential criticisms.

• Asset Encumbrance: A primary concern is that by segregating a pool of high-quality assets as collateral for covered bonds, the issuing bank "encumbers" these assets. This means a significant portion of the bank's best assets are no longer available to general unsecured creditors in the event of insolvency, potentially increasing the risk for those other creditors, including depositors not covered by deposit insurance.
• Complexi¹²ty: While simpler than some structured finance products, the legal and operational complexities of establishing and maintaining a dynamic cover pool, especially across different jurisdictions, can be substantial. This includes ensuring compliance with local legal frameworks and managing the continuous replacement of assets within the pool.
• Moral Ha¹¹zard: Some critics argue that the superior protection afforded to covered bondholders might create a moral hazard. If banks can issue very safe debt cheaply by encumbering assets, they might be incentivized to take on more risk with their remaining unencumbered assets, knowing that their covered bond funding is secure. The International Monetary Fund (IMF) has examined these potential side effects, including the possibility of increased risk for other bank creditors.,
• Limited^{10 9}Market Development (outside Europe): While prominent in Europe, the covered bond market has been slow to develop in other regions, such as the United States, due to different legal traditions, regulatory environments, and the dominance of alternative funding mechanisms like mortgage-backed securities.

Covered Bo⁸nds vs. Asset-backed Securities

Covered bonds are often confused with asset-backed securities (ABS), but there are crucial differences, primarily concerning recourse and balance sheet treatment.

The key distinction lies in the dual recourse and the fact that the underlying assets for covered bonds remain on the issuing bank's balance sheet. In contrast, with ABS, assets are typically sold off to an independent entity (a Special Purpose Vehicle or SPV), making the ABS investor's claim solely against the cash flows from those assets.,

FAQs

###^{7 6}What is dual recourse for covered bonds?

Dual recourse means that investors in covered bonds have two claims in case of the issuer's default: first, a preferential claim on the dedicated pool of collateral assets (the cover pool), and second, a general claim against the issuing bank's overall assets, similar to other senior unsecured creditors. This layered protection makes covered bonds very secure.,

Are cover⁵ed bonds considered safe investments?

Yes, covered bonds are widely regarded as very safe investments. Their dual recourse structure, the high quality of the underlying assets in the cover pool, and the robust legal and regulatory frameworks governing them contribute to their typically high credit ratings and low default rates.,

What kin⁴d³ of assets are typically in a covered bond cover pool?

The most common assets backing covered bonds are high-quality residential and commercial mortgage loans. Public sector loans, such as those made to municipalities or government entities, are also frequently used as collateral in cover pools.,

How do co²vered bonds help banks?

Covered bonds provide banks with a stable, long-term, and relatively inexpensive funding source. By issuing covered bonds, banks can convert illiquid assets like mortgage loans into cash, which can then be used to fund new lending activities, contributing to overall liquidity and supporting economic growth.,¹