Case for covered bonds
For investors looking for yields, diversification and a different approach to risk, covered bonds bear scrutiny
Weak global economic growth, coupled with fears of a prolonged recession in the eurozone, is expected to keep interest rates at low levels for a long period. At the same time, yields of bonds issued by the highly rated industrial companies have also fallen to record low levels. In such an environment, the expected real return of an investment in the safest bonds is likely to be negative.
Under these conditions, what are fixed income investors supposed to do? Faced with a difficult choice between accepting very low yields on the safest bonds and the increased uncertainty of bank debts, the need to find alternatives to this asset class becomes fairly imperative.
So what is the alternative? Is there an asset that can offer favourable yields and yet not see a significant rise in risk? One potential area to consider is covered bonds, which may be able to meet these requirements. Their yields are now at an attractive premium to government bonds, and they give investors additional security relative to unsecured bank debts.
A covered bond is a secured debt instrument issued by a credit institution (typically a bank) and backed by a pool of collateral (cover pool). Covered bonds are ‘dual recourse’ bonds, which means their owners have a claim against the institution that has issued them and, in the event the issuer fails, a prioritised claim on the cover pool.
Backed by quality assets
From the borrower’s perspective, the basic purpose of issuing covered bonds is to exploit a pool of high-quality assets and separate them from other assets in order to achieve cheaper funding. For investors, the appeal of covered bonds lies in their security and the pick-up in yields versus the safest government bonds.
Covered bonds play a pivotal role in wholesale funding for banks as they provide lenders with a cost-efficient instrument to raise long-term funding for mortgages or public-sector loans and offer investors top-quality exposure to lending institutions, through credit without a state guarantee. The importance of covered bonds for the financial system is reflected in the privileges that covered bonds enjoy in various areas of EU regulation.
At this point, covered bonds might seem like an asset class for institutional investors only. While it is not untrue that institutional players are significant in this market, covered bonds are not solely for this group. In particular, they should not be ignored by retail investors looking for advantages in terms of yields, credit quality and a broader diversity of assets, or diversification.
The two major categories of assets that are used to back covered bonds are mortgages and loans to the public sector. In the past decade, the covered bond market has developed into the most important segment of privately issued bonds on Europe’s capital markets, with a volume outstanding at the end of 2010 amounting to €2.5trn (£2trn), approximately one tenth of the aggregate euro-denominated bond market.