Covered bonds are debt securities issued by a financial institution and backed by a separate group of assets; in the event the financial institution becomes insolvent, the bond is covered. Covered bonds provide an efficient, lower-cost way for lenders to expand their business rather than issuing unsecured debt instruments.
Breaking Down Covered Bond
Covered bonds are derivative investments, similar to mortgage-backed and asset-backed securities (ABS), that are common in Europe and slowly gaining interest in the United States. A financial institution purchases investments that produce cash, typically mortgages or public sector loans, then assembles the investments together and issues bonds covered by the cash flowing from the investments. Issuing covered bonds allows financial institutions to buy and sell assets to improve credit quality, lower borrowing costs, and finance public debt. The institutions may replace defaulted or prepaid loans with performing loans to minimize the risk of the underlying assets.
Safety of Covered Bonds
The underlying loans of a covered bond stay on the balance sheet of the issuer. Therefore, if the institution becomes insolvent, investors holding the bonds may still receive their scheduled interest payments from the underlying assets of the bonds, as well as the principal at the bond’s maturity. Because of the extra layer of protection, covered bonds typically have AAA ratings.
Covered Bond Trends in the United States
In 1988, the European Union (EU) created guidelines for covered bond transactions that allow bond market investors to put more of their assets in covered bonds than previously allowed. In September 2007, Washington Mutual became the first U.S. bank issuing euro-based covered bonds. After U.S. Treasury Secretary Henry Paulson's announcement on July 28, 2008, about the Treasury and partnering institutions' plan to rev up the market for these securities, Bank of America became the first bank issuing dollar-based covered bonds. JPMorgan Chase, Wells Fargo, Citigroup, and other U.S. banks have also issued covered bonds. European banks have expressed interest in entering the U.S. market with euro-based covered bonds.
Benefits of Covered Bonds in the United States
Covered bonds may help U.S. banks raise extra funds that free up capital for financial activities, such as extending additional mortgages. The additional funds stimulate the economy by encouraging consumers to become homeowners. Covered bonds may also provide funds for increasing the development of infrastructure, thereby reducing the financial strain on local, state, and federal government agencies.
Example of a Covered Bond
In July 2016, Fitch ratings confirmed DBS Bank Ltd.’s outstanding mortgage-covered bonds, worth over $1.5 billion, were rated AAA. Bayfront Covered Bonds Pte. Ltd guaranteed the covered bond payments. The high rating was partly due to DBS Bank’s long-term issuer default rating of AA-, a stable discontinuity cap of three notches, and the asset percentage used in the asset coverage test of 85.5%.