What are Covered Bonds? | A Must-Know for Smart Investors

Introduction

 Bonds Investors always concern themselves with the safety of their money when making investments in bond markets. We all desire that our hard-earned money remains secure and doesn’t get lost in the market due to any crisis. In the world of investment finding the right balance between growing your money and ensuring it stays safe and sound is a key.  This is where Covered Bonds come in as a smart choice for those who want steady returns without compromising on safety. 

Covered bonds are debt securities issued by the financial institution and are backed by pool of assets. 

Here in this article, we will try to clarify the concept of Covered Bonds and explore relevant aspects.

What is a Covered Bond?

Covered bonds are type of debt securities which are hybrids of asset-backed securities and normal secured corporate bonds. Covered bonds are issued by banks or Non-Banking Financial Companies (NBFCs), which are backed by a pool of assets.  What makes them distinct is their dual recourse structure. These bonds are backed by a specific pool of assets, often consisting of high-quality loans such as mortgages. In the event of default, investors have a claim not only on the issuing bank’s general assets but also on the assets in the dedicated cover pool.

What are the features of the Covered Bonds?

1. Dual Recourse Structure: Covered bonds provide bondholders with a dual recourse, allowing them to claim on both the general assets of the issuing institution and a specific pool of assets (cover pool) in case of default. 
2. Asset Backing: These bonds are backed by a designated pool of high-quality assets, often comprising mortgages or public sector loans. The assets provide collateral to enhance the security of the bonds. 
3. Legal Separation: The assets in the cover pool are legally separated from the issuing institution’s bankruptcy estate, safeguarding them from being used to settle other claims. 
4. Ring-Fencing: The concept of ring-fencing ensures that the assets in the cover pool are exclusively dedicated to covering the claims of covered bondholders, even in financial distress. 
5. Transparency: Issuers typically provide regular updates and reports on the performance of the cover pool, offering transparency to investors. 
6. Issuer Responsibility: The issuing institution is responsible for maintaining the quality of the cover pool assets and ensuring compliance with regulatory requirements. 
7. Stable Cash Flows: The assets in the cover pool, such as mortgages, often generate stable and predictable cash flows, contributing to the stability of covered bonds. 
8. Investor Appeal: Covered bonds attract investors seeking a balance between security and returns, making them a popular choice in the fixed-income market. 
9. Lower Risk Profile: Due to the dual recourse structure and the high-quality nature of the assets in the cover pool, covered bonds are generally considered lower risk compared to traditional unsecured bonds. 
10. Regulatory Oversight: Covered bonds may be subject to specific regulations to ensure the soundness of the structure and protect the interests of bondholders.

How do Covered Bonds Work? Covered Bonds Structure

Below is the sequential manner in which the covered bond framework operates.

1. A financial institution, such as a bank or NBFC, issues bonds to investors. 
2. As a precautionary measure, a cover pool is established, comprising secured loans. 
3. An independent Special Purpose Vehicle (SPV) is often created to manage and safeguard the assets in the cover pool. 
4. Upon maturity, the financial institution repays the principal amount along with interest to the investors. 
5. In case of payment default by the issuer, recovery can be sought from the cover pool managed by the SPV. 
6. The cover pool typically includes various secured loans, such as housing, vehicle, gold, among others. 

 Still Confused about the covered bonds! No worries, we will explain it again with an example. 

Covered Bonds: Key Terms and Flows with Examples

Will learn about covered bonds in detail with examples and simultaneously explore key terms related to covered bonds.

What is a Mortgage Loan?

Company A is a housing finance company and provides loans to the homebuyers typically with loan maturity period from 15 to 30 years. These loans are supported by mortgages on the homes, hence known as “mortgage loans.”

What is Bond Against Mortgage Loan?

Now since the company A has given loans to the home seekers and has blocked its large capital, the company is in the need of money for its day-to-day operation.  In order to raise funds company A decided to issue bonds against the mortgage loans.

In simpler terms, Company A can use the homes it financed as a guarantee to borrow more money by issuing bonds. This helps them get the funds they need for their operations. 

What is the Pool of Assets?

The “pool of assets” here refers to the collection of mortgage loans held by the Company A.  

The Establishment of an SPV and the Transfer of Assets to the SPV

Company A transfers a pool of assets to its Special Purpose Vehicle (SPV). SPV is a separate legal entity set up for holding the cover pool. The pool of assets or cover pool are transferred from the issuing institution i.e. company A to the SPV. This transfer is often done through a legal process to ensure the assets are owned by the SPV. The SPV hold and manage the pool of mortgages, providing an additional layer of legal separation 

Cover pool is a set of assets owned by a SPV, exclusively meant to secure the bonds and protect the interests of bondholders. 

Covered Bonds are issued by an SPV

 The SPV issues covered bonds to investors, using the pool of mortgages as collateral. Investors now hold bonds backed by the mortgages on the homes. 

The mortgages in the SPV are now ring-fenced. This means they are legally separated from Company A bankruptcy estate. Even if ABC Bank faces financial difficulties, the assets in the SPV remain dedicated to covering the claims of covered bondholders. 

What are the Roles and Responsibilities of an SPV During Bankruptcy?

If Company A were to go bankrupt, the SPV and its assets are protected. Bondholders have a dual recourse: they can make claims on the general assets of Company A and on the assets in the SPV, specifically the mortgages. The SPV facilitates an orderly repayment process to bondholders. 

How an SPV Assists in Covered Bond Recovery During Bankruptcy?

The SPV manages the pool of assets and ensures their compliance with regulatory requirements. It also provides transparency by regularly updating investors on the performance of the cover pool. The SPV facilitates an orderly repayment process to bondholders. 

Advantages of Covered Bonds to Investors

1. For investor covered bonds provide high level of safety and stability. 
2. Dual recourse gives investors added protection in case of the issuer’s financial difficulties. 
3. Investors receive a consistent and predictable income stream from the bond’s cash flows. 
4. Covered bonds are actively traded, allowing investors to buy or sell them with ease. 
5. Investing in covered bonds tends to yield favorable returns. 

Benefits for Covered Bond Issuers

1. Issuers can borrow money at lower interest rates, reducing overall funding costs. 
2. Access to diverse funding sources helps in managing financial needs more flexibly. 
3. Longer repayment periods mean less pressure for frequent refinancing, providing stability. 
4. Issuers keep control and use of assets in the cover pool, maintaining operational flexibility. 
5. Issuers can build a positive market reputation by demonstrating financial strength through covered bond issuance.

What makes Covered Bonds an Attractive Investment? 

The safety of money that comes with the dual recourse structure of the covered bond makes it more appealing for investors to invest in it. In a scenario where the issuing institution faces financial trouble, investors can claim repayment from the overall assets of the issuer and also from the cover pool.  

A competitive interest rate is another compelling factor for investing in covered bonds, as they typically offer higher rates compared to alternative investment options.

Types of Covered Bonds

1. Soft bullet-covered bonds have a final maturity date. However, the issuer can extend the maturity date if the assets in the cover-pool are sufficient to cover the bond’s outstanding principal and interest payments. 
2. Hard bullet covered bonds are repaid at the initial maturity date if there is no issuer event of default and all tests are met. If the issuer defaults, all covered bonds are generally subject to a 12-month maturity extension.

Covered Bonds India : Types of Covered Bonds in the Indian Market

1. Legislative Covered Bonds: These bonds adhere to a specific legal framework provided by legislation in the issuer’s jurisdiction. The legal guidelines dictate the structure and features of the covered-bonds, ensuring standardized practices and investor protections. 
2. Contractual Covered Bonds: In contrast, contractual covered-bonds derive their legal framework from individual contracts between the issuer and investors. The terms and conditions are agreed upon in the bond documentation, allowing for greater flexibility but requiring a high level of trust between the parties involved.

Why is a Covered Bond Known as “Bankruptcy Remote” or “Bankruptcy Protected”?

Covered bonds are called “bankruptcy remote” or “bankruptcy protected” because they’re structured to keep bondholders safe if the issuing bank faces bankruptcy. They use a separate entity called a Special Purpose Vehicle (SPV) to hold onto the assets (cover pool) that back the bonds. So, even if the bank faces financial trouble, the SPV keeps those assets safe for bondholders, making covered bonds a safer investment.

Covered Bonds Vs Secured Bonds 

Choosing between covered bonds and secured bonds is like deciding between two characters in the fixed-income world.

Covered bonds, with their solid backing in assets like residential mortgages, come with a specific structure using a Special Purpose Vehicle (SPV). Investors get dual perks – claims on both the cover pool assets and the general assets of the issuer, all within a regulated setup.

On the flip side, secured bonds are the versatile players, offering flexibility with various collateral types. They’re not tied to a strict regulatory script like covered bonds, giving investors more freedom.

So, are you into the reliable and low-risk vibe of covered-bonds, or do you prefer the flexibility and diverse options of secured bonds? Maybe a mix of both is the way to go for a well-rounded investment strategy. 

Here’s a simple table comparing covered bonds and secured bonds: 

What are the risks associated with Covered Bonds?

Covered bonds are debt securities that are secured by a pool of high-quality assets, such as mortgages or public sector loans. These bonds provide an additional layer of security for investors because the assets in the cover pool serve as collateral. However, like any investment, covered-bonds are not without risks. Here are some potential risks associated with covered-bonds:

1. Credit Risk: While covered bonds are generally considered low-risk due to the presence of a cover pool, there is still some credit risk associated with the issuer. If the issuer’s creditworthiness deteriorates, it could impact the value and performance of the covered bonds.
2. Market Risk: The value of covered bonds can be influenced by changes in interest rates, market conditions, and investor sentiment. If interest rates rise, the value of existing bonds may fall, and vice versa. Market conditions can also affect the liquidity of covered bonds.
3. Liquidity Risk: Covered bonds may have lower liquidity compared to other more widely traded bonds. In times of market stress, it may be challenging to sell covered bonds at desired prices, leading to potential losses.
4. Refinancing Risk: Covered bonds often have long maturities, and issuers may face challenges when refinancing or rolling over maturing bonds, especially if market conditions are unfavorable.
5. Issuer-Specific Risks: The financial health and management decisions of the issuer can impact the performance of covered-bonds. Events such as bankruptcy or insolvency of the issuer could lead to default on the covered-bonds.
6. Asset Quality Risk: The quality of the assets in the cover pool is crucial. If the underlying assets, such as mortgages, default or decrease in value, it can affect the ability of the issuer to meet its obligations to bondholders.
7. Regulatory Changes: Changes in regulatory requirements or the legal framework governing covered-bonds can impact their structure and performance.
8. Currency Risk: If the covered-bonds are denominated in a currency different from the investor’s base currency, fluctuations in exchange rates can affect the returns.
9. Concentration Risk: If the cover pool is concentrated in a specific type of asset or geographic region, the performance of the covered-bonds may be more vulnerable to adverse developments in that particular market.

Investors should carefully assess these risks and conduct thorough due diligence before investing in covered-bonds. Additionally, credit rating agencies provide ratings that can help investors evaluate the creditworthiness of covered bond issuers.

Why Invest in Covered Bonds?

As we can see, there are many compelling reasons that make covered-bonds attractive to investors. They represent a secure investment option that yields favorable returns. The dual recourse feature of Covered Bonds enhances the security of the investment, making them an appealing choice for those seeking a balance between returns and safety.

1. Safety in Investment: Covered bonds offer a secure investment option, providing a relatively higher level of safety compared to asset-backed securities. Investors’ interests are protected even in the unfortunate event of the bond-issuing institution declaring bankruptcy.
2. Dual Recourse Advantage: The dual recourse feature enhances the safety of covered-bonds, making them an ideal investment tool for risk-averse investors. Under Dual Recourse, the issuer is obligated to make payments to investors from its own cash flow.
3. Attractive Returns: Investing in covered-bonds typically yields favorable returns. The interest rates have historically ranged between 8% and 12% (for India). For many investors, the appealing interest rates associated with covered-bonds are a primary attraction.

Who are the Investors in Covered Bonds?

Investors in covered-bonds span a spectrum from individual private investors to large institutional entities. This diverse group is characterized by individuals seeking long-term investment opportunities with a preference for low-risk ventures. Notable participants in the covered bond market include:

1. Bank Treasuries
2. Pension Funds
3. Insurance Companies
4. Central Banks
5. Asset Managers

Covered Bonds Interest Rates

The interest rates on covered-bonds can vary based on factors such as market conditions, issuer creditworthiness, and the specific terms of the bonds. Historically, covered bond interest rates have often been attractive to investors – ranged between 8% and 12% (for India) , typically falling within a range. However, the exact rates can change over time and are influenced by prevailing economic conditions.

For the most current and accurate information on covered bond interest rates, it is recommended to consult financial sources, bond issuers, or financial institutions offering these instruments.

How can an Individual Investor Buy Covered Bonds in India?

In India, bonds can be bought through RBI retail, brokers, banks, and online platforms. Mostly, covered bonds are mainly bought through the Wint Wealth platform.

Wint Wealth has introduced investment products like covered bonds that were once only accessible with a high initial investment, making them now within reach for everyone. You can explore these previously exclusive opportunities with a minimal investment starting at just ₹10,000. Traditionally, covered-bonds were initially only available to Ultra HNIs, with the ticket size ranging between Rs. 50 lakhs to 1 crore.

These investment opportunities are facilitated through partnerships with NBFCs, which issue the bonds. Once retail investors purchase the bonds, they receive monthly interest from the NBFCs, and the full principal amount is returned at the end of the investment tenure. Wint Wealth charges NBFCs issuing bonds on its platform approximately 1 to 1.5 percent of the entire transaction value processed. Wint Wealth acts as a bridge between NBFCs and retail investors.

Wint Wealth makes covered bonds more affordable for everyday investors.

Conclusion

In closing, covered bonds, especially with their dual recourse feature, offer a solid investment option that combines safety and potential returns. The added security of having both the issuer’s financial backing and a separate pool of assets makes them an appealing choice for those looking for stability in their investment portfolios. It’s important, though, to do your due diligence and consult with a financial advisor. This ensures that your investment aligns with your risk tolerance and financial goals. Handled wisely, covered bonds can be a valuable addition to a diversified investment strategy, providing a steady income while minimizing certain risks through their dual recourse mechanism.

Frequently Asked Questions (FAQs)

1. Is Covered Bonds safe for investment?

Yes, investing in covered bonds can be a safe choice. Consult your financial advisor for a better decision based on your risk profile.

2. Can I buy Covered bonds in Zerodha?

Wint Wealth, backed by Zerodha, allows investors to buy covered bonds. However, Zerodha has not yet listed covered bonds in coin platform.

3. How to buy covered bonds

In India, bonds can be bought through RBI retail, brokers, banks, and online platforms. Mostly, covered bonds are mainly bought through the Wint Wealth platform.

4. How are covered bonds taxed?

Covered bonds are taxed similarly to ordinary debt. Interest income from covered bonds is taxed at the investor’s marginal tax rate

5. Is a Covered Bond better than a Fixed Deposit?

Yes, Covered Bonds, with their dual recourse structure, can be considered better than Fixed Deposits due to added security and potential for slightly higher returns, depending on individual preferences and risk tolerance.

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