What are covered bonds?

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.

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.