Types of Bonds

Collateralised Bonds-Securitisation, Structured Products and Covered Bonds

Covered Bonds

Covered bonds are debt issued by banks that are fully collateralised by residential or commercial mortgage loans or by loans to public sector institutions. Covered bonds typically have the highest credit ratings, with most, but not all having AAA ratings. The notes offer an additional protection to bondholders than asset-backed debt because in addition to looking at the collateral pool as an ultimate source of repayment, the issuing bank is also liable for repayment, although in some cases the rating of the covered bonds is based more on the collateral than on the rating of the bank. If the issuing bank is downgraded, then the covered bond may also be downgraded but this depends on the specific situation.

Covered bonds are the second largest segment of the European bond market after government bonds. Germany, which created covered bonds known as Pfandbriefe to finance public works projects in 1770, leads issuance in the European covered bond market. Twenty four other European countries issue covered bonds to finance their mortgage markets and the most significant are Denmark’s realkreditobligationer at 16% segment of its market; France’s obligations foncières at 7%; Spain’s cedulas hipotecarias at 9% and Sweden’s säkerställda obligationers at 5%.

There are two types of covered bonds—those covered bonds that are subject to relevant national legislation, and also covered bonds that are not subject to national legislation, which are called “structured covered bonds.” As the covered bond world grows in importance, certain covered bond frameworks have been combined with techniques borrowed from securitisation. For those countries with covered bond laws, each different country’s covered bond laws regulate what assets are eligible to back covered bonds, the minimum quality requirements for the assets, and how investors will be protected if the issuing bank goes bankrupt. The national legislation does not say that the relevant government will guarantee repayment of the bonds, but rather the legislation stipulates how the collateral framework must operate. All countries with covered bond laws now allow for bonds backed by mortgages.

As there are different laws and rules for covered bonds in each country, it is important to assess the risks by understanding the particular investment you are concerned with, know the credit rating and consult a financial advisor for more information. Due to these different laws and rules, the spreads between covered bonds issued in different countries have recently widened considerably on the basis of the perceived risk by investors as to the repayment of the bond by issuers. This fact underscores the importance for potential investors to understand the underlying structure of the covered bond as this may impact the future pricing of that bond by the market.

Within the category of covered bonds backed by national legislation, there are two types of covered bonds, those backed by public sector loans or those backed by high quality mortgage loans. In general, maturities range from two to ten years, although the maturities are trending toward long term, greater than ten years.

Benefits of investing in covered bonds for individual investors include:

  • High credit ratings – Most covered bonds are rated at AA or AAA.
  • Diversification without credit quality dilution
  • Protection from default -- Covered bonds are full recourse debt, which means that if the issuer defaults, bondholders have a preferred claim on the assets in the cover pool and the proceeds arising from them.
  • Bullet principal payment at maturity – Since covered bonds are bank debt, and not solely backed by the underlying collateral, this permits simple bullet principal payments.

There may be tax advantages to investing in covered bonds. Consult your tax or financial advisor or the tax authority in the country where you live for more information.

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