I was asked an interesting question recently: Is it ever possible that, from an investor standpoint, it is worse to have a covered bond than a senior unsecured bond of the same issuer?That might sound like an abstract, and slightly pointless, thought experiment, but it was not.
The fact that the person asking me the question was a regulator points to the reason why. The growing number of covered bonds that dont conform to the European criteria for prudential treatment for investors (lower risk weight, better liquidity category, etc) suggests that the question might just start to be increasingly relevant.
Let me explain. In those countries where the European rules for investing in covered bonds dont apply (or dont apply yet, as appropriate) many investors of course want to buy covered bonds anyway. In an ideal world we will prove locally that covered bonds are as good as European Commission thinks they are and better prudential treatment will follow. Until then, until they become a special class of investment can a conservative regulator allow investors to buy covered bonds with exactly the same rules as they currently buy bank bonds?
Yes. But only if you can demonstrate that there is no circumstance in which they can be worse. Obviously assigning no value at all to the collateral is absurd but you have to do it if you want to get that covered bond onto this particular regulators approved investment list.
My answer you might disagree with me - was: yes. You can be worse off, but only in certain very limited circumstances and hopefully we can demonstrate to the regulator that these should not be cause for concern.
I break the possible reasons into two groups: market related and bond related.
The market related problems are the more straightforward. First, most obviously, you are getting a lower coupon on the covered bond than you are on the unsecured bond so you are worse off. Sorry. Ignore that one.
Then there is the market behaviour of the bond. In any scenario where the collateral is marked to zero obviously the assets will always be worth something. The only way that I could envisage this happening would be a legal challenge to the entire asset transfer it is reasonable to assume that the covered bonds will be less liquid than the equivalent unsecured bonds, even if the worst case scenario is that they have the same eventual recovery rate.
The market behaviour will also be worse because of a greater number of forced sellers investors who can only hold covered bonds. The legal challenge, or whatever other disaster scenario you can imagine would presumably make them ineligible assets for these investors. Holders of unsecured bonds might be more able to ride out the storm.
Of course these are temporary factors and any case where the market value is less for the covered than for the pari passu unsecured bond should presumably be arbitraged as long as the bonds really are economically equivalent.
But are they? More in my next post.
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