Covered Bonds

A covered bond is a type of senior debt obligation issued by a financial institution. It is usually backed by a segregated collection of assets consisting of commercial, public sector, or residential mortgages. The appropriate collateral and allowed structures in covered bonds differ depending on the jurisdiction.

Characteristics of Covered Bonds

• Covered bonds are like asset-backed securitites (ABS) but with dual recourse—to both the asset pool and the issuing financial institution. Recall that in an ABS, the financial institution to which the loan originates transfers the securitized assets to a bankruptcy-remote legal entity. However, in the case of covered bonds, the cover pool (pool of assets) is retained on the financial institution’s balance sheet, with the covered bondholders given top priority claim.
• Covered bonds consist of one class of bonds per cover pool. Recall that an ABS uses credit tranching to form bond classes with diverse default exposures.
• The cover pool in the covered bonds is dynamic in nature. Compared to mortgage loans (usually associated with prepayment risk), financial institutions to which the covered bonds originate must replace any prepaid or non-performing assets to guarantee sufficient cashflows until the covered bond matures.
• Covered bonds are associated with the redemption regimes. If the financial sponsor of the covered bonds defaults, the redemption regimes ensure that the covered bonds’ cash flows closely follow the initial maturity arrangement. As such, we have types of covered bonds:

1. 1. Hard-bullet covered bonds: If payments are not done as originally scheduled, bond default is initiated, and the bond payments sped up.
   2. Soft-bullet covered bonds: If payments are not done as originally scheduled, a bond default and acceleration of payments are delayed until a new maturity date (usually a year after the original date).
   3. Conditional pass-through covered bonds: If payments are not done as originally scheduled, covered bonds are converted into pass-through securities after the initial maturity date.

Risks of Covered Bonds

Covered bonds are usually associated with lower credit risks and lower yields as compared to an ABS.

Question

Which of the following statement(s) is/are most likely correct regarding covered bonds?

1. Like ABS, covered bonds use credit tranching to form bond classes with diverse default exposures.
2. Compared to otherwise similar ABS, covered bonds have lower credit risks with high yields.
3. In the case of hard-bullet covered bonds, if payments are not done as originally scheduled, bond default is initiated, and the bond payments accelerated.
4. The pool of assets in covered bonds is dynamic compared to a static pool of mortgage loans.

1. III.
2. I and II.
3. III and IV.

Solution

The correct answer is C.

Statement I is incorrect. Cover bonds are grouped in terms of the cover pools. That is one bond class per cover pool.

Statement II is incorrect. Covered bonds are usually bears have lower credit risks and lower returns compared with ABS.

Statement III is correct. In the case of hard-bullet covered bonds, if payments are not done as originally scheduled, bond default is initiated, and the bond payments sped up.

Statement IV is correct. The dynamic nature of the cover pool in the covered bonds obligates the financial sponsor to replace any prepaid or non-performing assets to guarantee sufficient cashflows until the maturity of the covered bond.