Covered Bonds

What are covered bonds?

Covered bonds are fixed income instruments that are secured by assets (mostly home and car loans on the books of financial institutions) also called a cover pool. This increases the safety of the Bonds.

Covered bonds are also called dual recourse bonds because the bondholder has two ways to recover the money in case of issuer financial stress. The first is to recover the money from the issuer directly (other assets) and the second is to sell the cover pool securing the bonds.

Issuers of covered bonds

Covered bonds are generally issued by financial institutions like banks and NBFCs. They secure the bonds with home and car (or other) loans that they have given out to retail borrowers.

Types of covered bonds

There are two types of covered bonds - legislative and contractual. Legislative covered bonds are regulated by a framework devised by the legislation. In India, there are no such frameworks for covered bonds yet. 

All covered bonds in India are contractual. Contractual covered bonds are governed by a contract/agreement between the issuer and the bondholder.

How do covered bonds work?

From the investor’s perspective, covered bonds work as regular bonds. Once an investment is made, investors receive regular interest payments and their principal is returned to them on the maturity of the bond. However, from the issuer’s perspective, covered bonds work a bit differently.

Covered bonds need to be secured by a pool of assets (generally home and car loans on a financial institution’s books). Without this pool of assets, the issuer cannot issue covered bonds.

How safe are covered bonds?

Covered bonds are considered to be extremely safe for the reason below:

Covered bonds are a unique bond category. This is because an issuer can issue a covered bond that can have a credit rating higher than the issuer’s. For example - An issuer with a credit rating of AA can issue covered bonds with a credit rating of AAA.

This is because covered bonds employ ‘credit enhancement.’ Simply put, by securing the bonds with assets, the issuer can obtain a higher credit rating on covered bonds. Hence, covered bonds are considered to be extremely safe.

Covered bonds versus ABS (asset-backed securities)

Covered bonds and asset-backed securities are very similar in structure yet different. They are similar because they have assets backing the bond which secure the bond. 

However, in the case of asset-backed securities, an SPV or a Special Purpose Vehicle exists. The loan is originated by an institution and is transferred on the books of the SPV. This makes the loan safe because even if the originator goes bankrupt, the investors are not affected.

In the case of covered bonds, no SPV exists. Additionally, covered bondholders have a dual recourse - one against the issuer and another against the cover pool. Investors of asset-backed securities have only one recourse - against the asset. Hence, covered bonds are safer than asset-backed securities.

Who should invest in covered bonds?

Covered bonds are safe instruments. However, they are complex to understand. This is the reason why covered bonds should be considered only by investors who have a firm understanding of what covered bonds are. Investors looking for capital safety and regular interest payments should consider investing in covered bonds.

Covered bonds versus corporate bonds

Even though covered and corporate bonds are both issued by companies, they are quite different.

Firstly, covered bonds are usually issued by financial institutions. Corporate bonds are all bonds issued by PSU and private sector companies. In a way, covered bonds are a subset of corporate bonds with a few distinct features.

A corporate bond may or may not be secured by assets. A covered bond is always secured by a cover pool.

A corporate bond has the same rating as the issuer while a covered bond generally is rated one notch above the issuer because of the presence of a cover pool.

Advantages of covered bonds

The biggest advantage of covered bonds is the credit enhancement technique used to make these bonds safer. This helps the investors and issuers both. Investors, because their money becomes safer with the backing of assets. Issuers, because they can issue bonds with a credit rating higher than their own!

Risks of investing in covered bonds

Covered bonds have the risk of regulations. In fact, after the 2021 regulations, covered bonds have hardly been issued. The future of covered bonds is uncertain right now.

Apart from this, covered bonds are subject to the usual risks associated with bonds like credit default risk, interest rate risk and liquidity risk.

How to identify the best covered bonds?

The best covered bonds for your money need 3 checks. Credit rating: choose a credit rating you are comfortable with. Interest rate: you should aim for covered bonds with higher interest rates. However, higher the interest rate, lower would be the rating of the bond. As a smart investor, the best covered bond for you needs to have the right balance. Finally, maturity date: ensure that the maturity date of the covered bond is aligned with your investment timeframe. You can eliminate interest rate and liquidity risks by holding a bond to its maturity.