Covered Bonds

Covered bonds are priority debt instruments, meaning they have a higher claim on the issuing financial institution’s assets or income in case of liquidation. These bonds are unique because a separate pool of high-quality assets backs them. Typically, the assets backing these bonds are commercial or residential mortgages or public sector assets, but they can also include other types of assets like ships and commercial aircraft.

Covered Bond Transaction Process

For covered bonds, the loans remain on the issuer’s balance sheet while being segregated or ring-fenced into a separate cover pool. This provides dual recourse for investors. In the event of bankruptcy, investors can claim against the assets in the cover pool and the unencumbered assets of the issuing institution. This ensures a heightened level of security.

The structure typically involves an issuer, usually a bank or financial institution, who creates and is accountable for the repayment of the covered bond. Each covered bond usually features one bond class per dynamic cover pool. The pools are managed by a servicer and overseen by a monitor or trustee. They ensure adherence to performance and underwriting standards and safeguard bondholders’ interests. Additionally, they maintain compliance and the performance of the asset pool. Issuers must replace non-performing or prepaid assets to maintain sufficient cash flows until bond maturity.

The evolving landscape is witnessing a rise in green-covered bonds. These bonds are primarily secured by mortgages to environmentally certified green buildings. This trend reflects the growing emphasis on environmental conservation and renewable energy in financial instruments.

Risk Mitigation

To mitigate investor risks, covered bonds use strategies like overcollateralization. In this approach, the collateral exceeds the face value of the issued bonds. They also maintain stringent Loan to Value (LTV) ratios on mortgages in the pool, ensuring that only eligible mortgages are included. In events of sponsor default, redemption regimes are structured to maintain the bond’s cash flow alignment with the original maturity schedule.

Different mechanisms trigger based on adherence to the payment schedule. With hard-bullet-covered bonds, any variance from the predetermined payment schedule activates a bond default and hastens the bond payments. On the other hand, soft-bullet bonds postpone bond default and the speeding up of bond payments until a revised final maturity date. This date is typically up to a year beyond the initial maturity date. If there are outstanding bond payments after the initial maturity date, conditional pass-through bonds transition to pass-through securities. Finally, if all bond payments are not completed by the original maturity date, conditional pass-through covered bonds transition into pass-through securities.

Comparison of Asset-Backed Securities (ABS) and Covered Bonds

The following table compares covered bonds and ABS.

$$\begin{array}{l|l|l}
\textbf{Feature} & \textbf{Covered Bonds} & \textbf{Asset-Backed Securities (ABS)} \\
\hline
\text{Issuer’s Balance Sheet} & \text{Loans remain on the} & \text{Loans are removed from the} \\
& \text{issuer’s balance sheet.} & \text{issuer’s balance sheet and} \\
& & \text{sold to a separate legal entity.} \\
\hline
\text{Recourse} & \text{Dual recourse: claim on the} & \text{Recourse only to the assets} \\
& \text{cover pool and, if insufficient,} & \text{in the pool; no claim if} \\
& \text{on the issuer’s unencumbered assets.} & \text{the pool is insufficient.} \\
\hline
\text{Risk and Yield} & \text{Lower credit risk with lower} & \text{Higher credit risk and} \\
& \text{yields due to added security.} & \text{can offer higher yields.} \\
\hline
\text{Asset Management} & \text{Assets are managed dynamically} & \text{Once assets are securitized,} \\
& \text{with replacement of non-performing} & \text{not managed dynamically,} \\
& \text{assets to maintain cash flows.} & \text{performance impacts security value.} \\
\hline
\text{Regulation and Oversight} & \text{Stringent regulation and} & \text{Less stringent regulatory} \\
& \text{oversight to protect bondholders.} & \text{requirements vary by} \\
& & \text{jurisdiction and asset type.} \\
\hline
\text{Market Impact} & \text{More stable during market} & \text{More volatile in fluctuating} \\
& \text{fluctuations due to requirements} & \text{markets due to direct impact} \\
& \text{and dual recourse.} & \text{of asset performance.} \\
\hline
\text{Use of Funds} & \text{Used for funding mortgages,} & \text{Diverse, from credit card} \\
& \text{public sector loans, and green projects.} & \text{receivables to auto loans} \\
& & \text{and student loans.} \\
\end{array}
$$

Question

Which of the following is most accurate regarding covered bonds?

1. After the asset pool supporting covered bonds is securitized, it is usually not managed in a dynamic manner.
2. Covered bonds are typically associated with higher credit risk and offer higher yields than similar ABS.
3. Covered bonds often feature overcollateralization, where the collateral underlying the transaction surpasses the face value of the bonds issued.

The correct answer is C.

Covered bonds often feature overcollateralization as a strategy to mitigate investor risks, where the collateral underlying the transaction surpasses the bonds’ face value.

A is incorrect: The assets in covered bonds are managed dynamically, and non-performing assets are typically replaced to maintain sufficient cash flows until bond maturity.

B is also incorrect: Covered bonds have lower credit risk and offer lower yields due to the added security and dual recourse nature compared to similar Asset-Backed Securities (ABS).