Ten Things You Should Know About Covered Bonds

Covered bonds have been a mainstay of European asset-based funding for centuries, but they are still little-known in the U.S.  Here are the ten most important things to understand:

   1. Covered bonds are debt obligations that have recourse to a pool of assets—the cover pool—that secures or "covers" the bond if the issuer becomes insolvent. One reason covered bonds are considered such a safe investment is that they offer dual recourse for payment. Bondholders can rely on recourse to the assets in the cover pool as well as to the issuer.

   2. Cover pools are called dynamic (rather than static) because their contents can be enhanced over time by adding more or different assets. If some assets in the pool deteriorate, they can be replaced. Unlike with mortgage-backed securities (MBS) or collateralized debt obligations (CDOs), if the overall value of the assets declines, the drop can be mitigated by increasing the amount of over-collateralization. This can help ensure that the level of quality in place when the investor buys a covered bond will remain stable throughout the life of the bond.

   3. It has been estimated that covered bonds comprise a nearly $3 trillion (USD) market. As secured investments, historically they have carried yields from 20 to 100 basis points lower than senior unsecured bank debt of comparable quality. Covered bond programs in a number of non-European countries have recently started or are in progress.  There have been only two U.S. issuers of covered bonds to date—Washington Mutual (2006) (whose program is now sponsored by J.P. Morgan) and Bank of America (2007). Those bonds were sold primarily in Europe. The U.S. Covered Bond Council—formed in 2008 by the Securities Industry and Financial Markets Association (SIFMA)—is expected to be a central player in the nascent U.S. covered bond market.

   4. Covered bonds are usually associated with high-quality assets of three types: residential or commercial mortgages, public-sector debt, or shipping loans. But the types of quality assets that could potentially be used as the collateral for a covered bond are limited only by investor demand. Although most issuers are financial institutions, covered bonds may also be issued by corporations including insurance companies or any other business with assets well-suited for inclusion in a cover pool.

   5. Underwriting standards are likely to be more conservative with covered bonds because the collateral pool is being monitored and updated every month on the issuer's own balance sheet. Issuers know they will remain on the hook for how the collateral performs over the long term.

   6. Bond governance and trust compliance requirements in covered bond structures reduce opportunities for conflicts of interest on the part of the issuer. The independent trustees, asset monitors, and master servicers typically associated with covered bonds provide a high level of checks and balances. In addition, investors who value transparency and granular disclosures are likely to find greater satisfaction with the loan-level details and updates provided for many covered bonds. Such bonds suffer less from the data "camouflaging" inherent in weighted-average pools or catch-all de minimis provisions often found in ABS /MBS structures.

   7. Because of their typical bullet structure (repaying principal at maturity) and asset substitution feature, covered bonds offer much more protection against prepayment risk than is possible with residential mortgage-backed securities (RMBS).

   8. In most countries where covered bonds are issued, the instrument is governed by specific laws.   Although the U.S. does not yet have a covered bond statute, efforts to establish a comprehensive legislative framework—which many experts believe is essential to develop a market here—are underway in Congress.

   9. At present, two key documents provide federal guidance for U.S. covered bonds—one from the FDIC, the other from the U.S. Treasury Department. The FDIC's Covered Bond Policy Statement (Final), issued July 2008, aims to facilitate "prudent" development of a U.S. covered bond market by specifying how it will treat such bonds in the event that an insured depository institution goes into conservatorship or receivership. Treasury's "Best Practices" for residential covered bonds "seeks to bring increased clarity and homogeneity to the U.S. Covered Bond market by developing a series of Best Practices." Regulators with interest or oversight related to the U.S. covered bond market would include the FDIC, SEC, U.S. Treasury, and the Federal Reserve System, among others.

  10. In the U.S., potential covered bond issuers are more likely to be found among financial institutions that have a long-term perspective on capital funding and favor a diversified approach. At present, covered bonds are disadvantaged by government-subsidized and/or government-guaranteed financing vehicles and by the current lower capital requirements of off-balance sheet funding. But those conditions are unlikely to remain in place indefinitely.