A covered bond is a bank bond that benefits from both a full recourse to the issuer and security over a revolving pool of assets, typically mortgages or public sector receivables. Covered bonds are subject to special public supervision and are created by law. In the European Union they benefit from preferential prudential rules for many classes of investor as defined in the Covered Bond Directive. These rules can start to apply to non-EU covered bonds that meet equivalent standards from July 2024.
A typical covered bond will be €500mn to €1bn with a medium term maturity, such as 5 years. It will most likely be backed by prime residential mortgages and issued by a mainstream European bank. Typically it will be rated AAA or AA by one or two major rating agencies and will be in standard listed Eurobond format. There are exceptions to all of these rules!
Covered bonds differ from asset backed securities in three key ways: 1. They have dual recourse to both the issuer and the pool of assets. 2. They are defined by law, which also sets down the regime for public supervision to protect the interests of the bonds holders. 3. They must be backed by limited types of assets defined in national and EU law.
The total market for covered bonds is approximately €3trillion, with about €500billion of new bonds being issued in a typical year. The market is dominated by European issuance, but non-European issuance is growing rapidly.
Junior covered bonds are a negligible and highly technical subset of the Danish covered bond market. They have a junior ranking secured claim to the pool of assets, in order to protect the credit rating of the main bonds in the cover pool. Technically under EU law, they are not really covered bonds because they are junior.
Until recently covered bonds have not been explicitly covered in the BIS rules for banks, but only recognised in EU law. This grants preferential treatment for some classes of investors in qualifying covered bonds. In autumn 2017 the BIS, as part of the Basle iii package, recommended a global acceptance of the concept.
Whilst there is no official market standard yet, green covered bonds are structured within existing covered bond law & regulation and often from the same programme (on an equal footing with regular covered bonds in insolvency). However, the proceeds of the issue are ringfenced for eligible assets and also achieve environmental benefits. The bonds must always be secured by an equal number of green loans in the total cover pool. Luxemburg is looking at introducing a covered bond framework dedicated to green assets.
The covered bond label is a voluntary, market led initiative run by the European Covered Bond Council. It attempts to define the market and to establish minimum standards to protect investors in particular with regard to high and standardised level of disclosure. As of February 2023 126 issuers from 24 countries have over €2trillion of labelled covered bonds.
A European Secured Note is a proposed funding instrument that takes technology, honed in the covered bond market, and applies it to other asset classes not allowed under traditional covered bond laws (in particular loans to SME's and infrastructure projects). Whilst the market has not yet developed, the European Commission is actively investigating whether it could be a viable way to improve the flow of funds into the real economy.
Traditionally, covered bonds are backed by public sector receivables and mortgages. A small number of countries also allow mortgages on ships as collateral. Whereas there are many definitions of the assets on a country-by-country basis (and occasionally other asset classes allowed), these three broad asset classes are recognised at an EU level as the basis for preferential prudential treatment for investors.
The Covered Bond Directive, currently being discussed, is designed to ensure a minimum standard for covered bonds. This is to support their prudential treatment and create a level playing field for issuers across Europe. It introduces many principles that must be converted into national law – largely based on proposals from the European Banking Authority - and some more specific rules regarding, for example, minimum over-collateralisation levels and levels of liquidity assets. Every country is expected to make at least some amendments to their laws and/or regulations to reflect the proposals.
Opinions differ. Whereas traditionally German covered bonds (Pfandbrief) are the most expensive (that is, investors require a lower yield), there is an ongoing debate about the extent to which this is because German investors are such a dominant part of the overall market. One way to consider the quality of a covered bond is the credit rating, relative to the credit rating of the same issuer – that is the rating uplift that they provide. According to the rating agencies, many jurisdictions have broadly similar levels of potential uplift. Every covered bond market develops for the specificities of the market that it funds.
Covered Bonds Worldwide
Explore how covered bond markets differ by continent and country.
Relative to the size of its economy, the Danish covered bond market is the largest in the world and finances all residential mortgages in the country. There are more covered bonds outstanding than there are government bonds, making it the key part of the Danish krone fixed income market. The market also contains many features not found in other covered bond markets. Whilst these are highly effective and have contributed to the success of the market, they sometimes hinder initiatives to harmonise European covered bond processes.
France has one of the oldest largest and most diverse covered bond markets in Europe. The 19 issuers in the country have a choice of three separate covered bond structures – Societes de Credit Foncier – dedicated special bond banks, Societes de Financement de l’Habitat – entities typically used by the high street banks to refinance mortgages and the covered bond issuing agency Caisse de Refinancement de l’Habitat. Unusually some French issuers use ‘mixed pools’ – which combine mortgages and public sector receivables.
German covered bonds are (arguably) the oldest covered bond market in the world with origins dating back to the 18th century. Although the total amount of bonds outstanding has been in steady decline - from a peak of over €1trillion in 2003 - they are still either the first or second largest covered bond market in the world (almost exactly equal to the Danish market). They are also known by their German legal name of pfandbrief.
Uniquely, buyers of Spanish covered bonds have a claim on the entire mortgage portfolio of the issuing bank – not just a dedicated cover pool. This has given them typically the highest over-collateralisation ratios in Europe, a fact which served them well in the severe downturn in the Spanish housing market after the financial crisis. Spanish savings banks pioneered the ‘multi-seller’ structure where several issuers would pool their funding needs to launch large, liquid securities. The Spanish covered bond market is likely to undergo substantial changes as a result of the covered bond directive.
Covered bonds and their forerunners have been used for many years to fund a substantial portion of the residential mortgages in Sweden. With over €200bn equivalent outstanding, Sweden is one of the top 5 countries in the world in terms of covered bond market size. Most bonds are issued in Krone to domestic investors, but with a substantial minority of the market funded in euros.
Covered bonds have been used by British banks to fund their mortgage portfolios since 2003 and have been subject to FCA (or FSA regulations) since 2008. Although at their peak there were over €200bn outstanding, their use has declined as UK bank’s overall public market funding needs have declined (and the regulatory capital arbitrage available in the securitisation market has been more appealing). Although UK covered bonds are fully compliant with all EU legislation, currently their status for European investors after Brexit remains unclear.
Covered bonds are issued by several Canadian banks to fund portfolios of prime residential mortgages in Canada. They are typically structured in a very similar way to those in Europe and as such have been very well received by rating agencies and European investors. They were initially structured under contract law, but since 2012 have been regulated by the Canadian Mortgage and Housing Corporation. There are approximately €100bn outstanding.
Historically the US, in contrast to Europe, has not used covered bonds to fund residential mortgages. There have been some attempts to ‘kick start’ the market - with the use of bonds structured under contract law - but objections from the FDIC, and the dominant role of the GSEs in the American housing market, have hindered the market’s growth to date. Some non-US covered bonds are issued in US dollars typically under rule 144a.
In Asia, several countries are considering introducing covered bond frameworks, particularly in light of the success of the Singaporean market. India, Malaysia and China, in particular, are also believed to be looking into the instrument.
Covered bonds are issued by several Australian banks to fund portfolios of prime residential mortgages. They are typically structured in a very similar way to those in Europe and as such, have been very well received by rating agencies and European investors. They were introduced by the government in order to increase the funding options for Australian ADIs in a stressed environment. They are regulated by APRA notice APS121 and there are €71bn outstanding.
Covered bonds were first issued in New Zealand in 2010 – a whole year ahead of their much slower Australian neighbours. They used contract law, following the pattern of initial covered bonds in countries like the Netherlands and the UK. But in 2013 the New Zealand parliament passed a law detailing the supervisory processes, disclosure and investor protection for the market which has since grown to over €10bn outstanding. Of the five active issuers only one is not a subsidiary of an Australian parent bank.
Covered bonds are issued by several Singaporean banks, secured on portfolios of residential mortgages. They are structured in a similar way to most European covered bonds and have been well received by investors, mainly in Euros, but also in Australian and US dollars and in sterling. They are regulated by the Monetary Authority of Singapore and are subject to MAS notice 648.
Covered bonds have been issued in South Korea since 2009. Initially they were issued on a structured basis under contract law and since 2014, under an act of the Korean Parliament. The state owned Korean Housing Finance Corporation is the largest issuer of covered bonds under the act, issuing on behalf of the participating banks to whom it on lends the proceeds of the bonds. With less then €3bn outstanding, the market is clearly a long way behind its potential. However in 2018, the financial regulator announced plans that could significantly increase issuance and could increase the demand for covered bonds from domestic issuers.
ECBC Factbook
