Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet. However, there exist other variable types where assets come off Balance Sheet.
A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. These assets act as additional credit cover; they do not have any bearing on the contractual cash flow to the investor, as is the case with Securitized assets. Before the outbreak of the Financial Crisis in 2008, this enhancement typically (although not always) resulted in the bonds being assigned AAA credit ratings. Due to the realization that many of the loans backing these bonds were of a low quality, credit ratings declined sharply. This diminished the demand for all the types of asset backed or covered bonds, contributing to the Global Financial Crisis.
For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.
Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.
Covered bonds were created in Prussia in 1769 by Frederick The Great and in Denmark in 1795. Danish covered bond lending emerged after the Great Fire of Copenhagen in 1795, when a quarter of the city burnt to the ground. After the fire, a great need arose for an organized credit market as a large number of new buildings were needed over a short period of time. Today nearly all real estate is financed with covered bonds in Denmark, and Denmark is the 3rd largest issuer in Europe.
In Prussia these Pfandbriefe were sold by estates of the country and regulated under public law. They were secured by real estate and subsidiary by the issuing estate. In about 1850, the first mortgage banks were allowed to sell Pfandbriefe as a means to refinance mortgage loans.With the mortgage banks law of 1900, the whole German Empire was given a standardized legal foundation for the issuance of Pfandbriefe.
Pfandbriefe are quite common in Germany and Europe and are utilized as a financial instrument with great success. In its more than 200 years of history, there was not even a single case of a defaulted Pfandbrief.
For this reason and due to the security provided by the cover pool, covered bonds were one of the first markets to recover following the global financial crisis of late 2008.
On 28 July 2008, US Treasury Secretary Henry Paulson announced that, along with four large US banks, the Treasury would attempt to kick-start a market for these securities in the USA, primarily to provide an alternative form of mortgage-backed securities. The guidelines issued specifically address covered bonds backed by pools of eligible mortgages.
The Federal Reserve also announced that it would potentially consider highly rated covered bonds as acceptable collateral for emergency fund requests. Because the United States has already shown a robust market for other securitized debt products, regulators have been promoting the covered bond market strategy.
On 3 June 2010, Bank of New Zealand announced that it had launched the first covered bond programme in Australasia. Covered bonds issued by Bank of New Zealand will be rated 'Aaa' by Moody's Investor Service and 'AAA' by Fitch Ratings. No issuers in New Zealand, Australia or surrounding countries have issued covered bonds previously.
On 12 December 2010, the Treasurer of Australia, Wayne Swan, announced that Australia would change its financial regulations to allow covered bonds. The Australian Securitisation Forum has attempted to get APRA to allow ADI's to issue these bonds for several years - without success. More recently the major Banks have been lobbying for this, stating that Australian Banks would be at a disadvantage to their international counterparts.
Legislation authorizing issuance of covered bonds by Australian financial institutions won support from the minority Labor government and the opposition in the house of representatives on the 12th of October 2011. The bill then passed to the senate where it was passed the next day, 13 October.
In November 2011 ANZ Banking Group released Australia's first Covered Bond issue.
- The Covered Bond Report (covered bond news and data available free to investors)
- The Cover (daily news, priced deals, pipeline and league tables on the covered bond market)
- Covered Bond InvestorTM (free news, analysis & resources)
- US Treasury Best Practices for Residential Covered Bonds
- FDIC Policy Statement on Covered Bonds
- ECBC Technical Issues Covered Bond Comparative Framework Database
- ICMA Covered Bond Investor Council (CBIC)