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Over the past decade, covered bonds simply illustrated as securities that may be issued by credit institutions that are secured by a protected pool of high quality assets. The collateral usually put together is done so as to obtain the highest possible credit rating. The European Covered Bond Council (ECBC) sets out what it considers to be the essential features of covered bonds:
The dual nature of protection offered to investors is amongst the defining features of covered bonds, which has led to its popularity. This is done, by them having been offered by a financial institution, besides being backed by a special pool of collateral. If the bank defaults on its bond, the investor has recourse to both the issuer and the underlying assets. Covered-bond holders are first in line to claim the mortgages backing their bonds.
These bonds have achieved a high degree of success in the European markets, as visible from the chart above. The US as on the same period (2014) issued 4 bn worth of Covered Bonds.
As per the ECBC, covered bonds represent a key funding tool for the banking industry. They are an effective way of channelling long-term financing for high quality assets at a reasonable cost. They improve the banks’ ability to borrow and lend over long-term horizons and, therefore, represent a stable source of funding for key banking functions such as housing loans and public infrastructure. For instance, long-term financing is crucial for housing finance. Given the size of the investment, their repayment must be spread out over a long period to be compatible with their annual savings capacity. Long-term funding tools for banks are therefore required to avoid asset and liabilities mismatches. Covered bonds are typically designed to support this mortgage lending.
In times of low risk appetite from investors, covered bonds play an essential role in ensuring the flow of capital in financing long-term growth and the real economy. They offer key safety features such as a strict legal and supervisory framework, asset segregation, and a cover pool actively managed in order to maintain the quality of the collateral. During the recent financial turmoil, the existence of a well-functioning covered bond market has allowed governments in Europe to constantly channel private sector funds to housing markets and maintain a relatively efficient lending activity without increasing the burden for taxpayers and public debt, notes the ECBC.
In March this year, Germany’s Berlin Hyp became the first bank to issue a covered bond at a negative yield. Canadian Imperial Bank of Commerce has more recently sold a benchmark covered bond at a negative yield, raising almost USD 1.8 bn.
While the European region boasts of a strong framework to support this asset class, it is yet to evolve beyond these shores. The ECBC summaries, the increased recognition by policymakers and regulators of the central role that the asset class plays for the banking system and also for wider financial stability reinforces the need for an appropriate regulatory framework for covered bonds at both European and international levels.