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Understanding the Basics of Covered Bonds

BY: Chirag Sharma | Category: Finance | Submitted: 2012-12-08 23:03:54
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The growing share of the covered bonds in the Bond market attracts lot of attention towards them. The covered bonds were primarily issued in Germany and Denmark until mid-1990s. With the introduction of covered bond legislation in more countries, especially in the EU and now the Asian countries, the market has grown considerably.

For wealth managers who are interested in investing in safe assets covered bonds provide an excellent opportunity. Covered bonds are quite similar to the regular bonds with added layer of protection. The bonds are covered by cash flows generated from a pool of assets called "cover pool" which are provided as collateral to the claims of the bondholders. Unlike the asset backed securities or mortgage backed securities, covered bonds lie on the balance sheet and similar to any other bond issued by the borrower. With the difference being that the bond is secured against the cash flows of the collateral asset. The bonds have double safety, as it is an obligation to the issuer as well has a dedicated asset pool for claims.

Unlike the corporate bonds, which are generally secured against the assets of the issuer, the investor might have to take a haircut if the issuer goes bankrupt. However, in case of covered bonds, the investors have access to the cover pool even after the issuer goes bankrupt and gets interest and principal from the cash flows of the cover pool. The issuer has to ensure that the asset pool collateral covers the claims of bondholders at all times. Because of such ongoing-obligation and bankruptcy-remoteness the bonds are rated better and trade at yields lower than the senior or unsecured bonds.

The covered bonds are the regarded safe due to its inherent features. EU directives require the bonds to have certain features in them to be considered as covered bonds. Among other things, the bonds must be issued by credit institution, the asset pool to be eligible as per law and the cash flows from the asset pool must provide enough collateral to cover bondholders' claims throughout the whole term of these bonds. Also bond holders must have priority of claim over the asset pool in case of bankruptcy of the issuer.

The covered bonds are governed by general law, however in certain countries they are governed by the specific legal framework and have legal binding regulations of a public supervisory authority. In such special-law based frameworks, the issuer is required to obtain a license to issue covered bonds, which is generally issued by the designated public authority.

The EU directives have allowed UCITS funds to invest up to 25% of their funds in a single borrower covered bonds and also allows the insurance companies to invest up to 40% in covered bonds by same issuer. Apart from this the covered bonds also enjoy certain privileged risk weightings in assessing the capital adequacy of banks invested in covered bonds. Canada and Australia have successfully tapped the covered bond market in a very short span of time. Asian countries also have been taking keen interest in covered bonds, with some of them making necessary legislation changes. Latest in the news was South Korea trying to set up legal framework for covered bonds.

About Author / Additional Info:
Chirag Sharma is Digital Marketing Consultant in SJ Seymour group headquartered in Hong Kong. SJS Markets provides research, advisory, execution services and private Wealth Management Solutions.

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