Covered Bonds
Covered bonds are unique in their dual nature of protection offered to investors. These are issued by banks which are liable for repayment and are backed by high quality mortgages1 or loans to public sector. Investors have priority claim on the underlying assets. Covered bonds are considered as a high yielding2 alternative to government bonds rather than an instrument to obtain exposure to credit risk. Covered bonds are very different from ABS in many ways. Cover pools are used for improving credit worthiness and not as a means for getting exposure to underlying assets as in the case of ABS. Also, covered bonds have fixed rates whereas ABS have a floating rate and may pass defaults and early repayment directly to the investors. Jumbos (large issues of covered bonds) are traded in the secondary market which makes them more liquid than ABS. As per the September 07 BIS report, covered bond market has become one of the largest asset classes in the European bond market and the prominent source of finance for mortgage lending in the last decade. As of mid-2007, the outstanding amount of covered bonds has reached 1.6 trillion.
More countries are beginning to have legislations on the covered bond market which covers stipulations like loan-to-value ratio (LTV). Also, the risk of bankruptcy of the originator poses issues like value of cover pool in that event and the possibility of their creditor’s trying to access the cover pool. These are not issues practically seen; as such a bankruptcy hasn’t yet happened. Also, the three rating agencies (Moody’s, S&P and Fitch) have differing methodologies to rate the risk in covered bonds. This adds to the difficulty of risk assessment.
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1. Covered bonds are long term fixed rate instruments, so they are suited to refinance fixed rate mortgages.2. Yields on covered bonds are lower than senior, unsecured loans of the same originator.