Covered bonds are debt securities issued by a bank or mortgage institution and collateralised against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time. They are subject to specific legislation to protect bond holders. Unlike asset-backed securities created in securitization, the covered bonds continue as obligations of the issuer; in essence, the investor has recourse against the issuer and the collateral, sometimes known as "dual recourse." Typically, covered bond assets remain on the issuer's consolidated balance sheet (usually with an appropriate capital charge).
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.
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.
- Basel Committee on Banking Supervision, Supervisory framework for measuring and controlling large exposures, page 12
- Lemke, Lins and Picard, Mortgage-Backed Securities, §4:22 (Thomson West, 2013 ed.).
- "2013 ECBC European Covered Bond Fact Book". Archived from the original on 2014-05-14. Retrieved 2014-04-15.