A covered bond is a generally fixed-rate capital market debt instrument issued directly by a financial institution that is liable for the security’s repayment and backed by a special pool of collateral to which investors have a priority claim. Secured by both the issuer’s creditworthiness and a high-quality collateral pool, mostly high-grade mortgages or loans to the public sector, covered bonds have a higher rating than “plain vanilla” bank bonds.
Covered Bond Exposure by Country per 31 Jan 2014 (€bn) | |||||
Germany | Spain | France | Italy | Austria | |
Germany | 144,759 | 0 | 511 | 0 | 0 |
Belgium | 1,887 | 0 | 252 | 0 | 0 |
France | 1,519 | 0 | 51,562 | 0 | 0 |
Italy | 3,305 | 0 | 7,181 | 8,157 | 0 |
Netherlands | 131 | 0 | 0 | 0 | 0 |
Austria | 2,729 | 0 | 197 | 0 | 12,084 |
Spain | 5,059 | 30,336 | 693 | 0 | 0 |
Source: European Covered Bond Council |
In the European Union, covered bonds are defined in the Capital Requirements Directive (CRD). While the CRD only recognizes securities issued under special legislation as covered bonds, a number of “structured covered bonds” have been issued under private contractual arrangements using elements from structured finance, primarily in EU and non-EU countries without special covered bond legislation, including the United States.
Characteristics that distinguish covered bonds from collateralized debt obligations (CDOs) include:
- They are issued by the asset originator, not a bankruptcy-remote special purpose vehicle (SPV);
- The pooled assets normally remain on the balance sheet where they originated;
- The pooled assets are actively managed, thereby allowing the issuers to replace assets that have either lost quality or been repaid early;
- There is no tranching of securities, thus all bonds of a certain issue are fungible with each other; and
They use a pay-through structure, such that the payment of interest and principal is passed to investors in the same period in which the payments are received, providing certainty on cash flow timing.