A covered bond is a collateralized bullet bond backed by either mortgage loans or loans to the public sector. Covered bonds originated in Germany where they are known as Pfandbriefe, and have been in existence for over 200 years. They are the largest single bond type in Europe, and are a standard feature of European markets.
A recognised asset class in their own right, they are attractive to long-term institutional investors. They offer investors liquid markets, government-like credit quality as well as pick up on yield.
They are an attractive method of funding for financial institutions as they offer the prospect of raising funds in a cost-effective manner, and, as a consequence, they can have a substantial and beneficial impact on competitiveness
The bonds are secured on a pool of underlying assets known as cover assets. These asset pools are dynamic, as assets that disimprove in quality may be replaced by new and better assets. Unlike conventional securitisation, these assets remain the property of the institution issuing the securities and remain on that institution's balance sheet. Therefore, their spreads over sovereign bonds are attributable to liquidity and credit quality alone. In fact, Pfandbriefe are highly rated and have relatively small spreads. These low spreads are more a reflection of the quality of the collateral pool (which is subject to strict government regulation) than the perceived quality of the issuing agent.
Covered bonds are very secure assets as investors benefit from a preferential right in bankruptcy. In the event of insolvency of the issuing institution, the cover assets must be used first to meet the claims of the holders of the securities. Ordinary creditors may not make a claim against these assets until the full obligation due to the investors in the securities has been discharged. Moreover, no covered bond has defaulted this century.
Jumbo Pfandbriefe are covered bonds with a minimum issuance of 500 million euros, and are mainly backed by public sector loans rather than mortgage loans. Jumbos are responsible for the increased liquidity in the market, as they are of a large volume, and have active market making in the secondary market. In Germany, around half of new Pfandbrief issues are now Jumbo Pfandbriefe.
While covered bonds originated in Germany, they are now common throughout Europe. In France, Luxembourg, Finland and Ireland new laws came into effect, which allowed the issuance of covered bonds. In Spain the existing laws became more attractive. Further covered bond initiatives are being discussed in Belgium.
Key Terms:
• EuroMTS - electronic trading system, increases liquidity and tradability
• Designated Credit institutions- issuers of mortgage or public credit covered securities
• Cover asset monitor - ensures the organisation is complying with specified sections of the legislation that protect the high quality of the cover assets. |
