Conditional Pass-Through Covered Bond
February 12, 2025
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Asset-backed securities have become famous all over the world in the past few years.
The largest market for asset-backed securities was in the United States of America. The sub-prime mortgage exposed the flaws inherent in the process of issuance of asset-backed securities.
The world had been looking for an alternative to asset-backed securities. This is where covered bonds have started gaining popularity.
Covered bonds are a distinct type of fixed income instrument which are somewhat similar to asset-backed securities. These types of bonds earlier originated in Germany. However, over time, they have become quite popular in most parts of the world. The changed Basel norms have created a huge demand for these covered bonds.
In this article, we will have a closer look at what covered bonds are as well as the advantages and disadvantages of using covered bonds.
Covered bonds are similar to asset-backed securities in the sense that they too are created after the securitization of a pool of loans or assets. However, the defining feature of covered bonds is the fact that investors in these bonds have “dual recourse”. This means that in the event of a default, the investors would first have a claim on underlying assets which were collateralized to issue these securities.
These securities are ring-fenced so that the financial health of the parent company does not impact them. Hence, in the event of a default, first, these assets will be sold to make good the losses.
However, if the assets are not enough to make good all the losses, then the investors will also have an unconditional claim on the issuer of these securities. This means that, unlike asset-backed securities, these bonds continue to stay on the books of the organization which issued them.
The dual recourse feature makes these bonds amongst the safest in the world. Hence, they are virtually at the very top of the fixed income structure.
Even though such types of bonds have existed in Germany for almost a century, they have risen in popularity in the recent past. At present, covered bonds are one of the highest issued bonds in the world. It is estimated that there is more than $1.1 trillion worth of covered bonds outstanding in the world.
Covered bonds provide some distinct advantages to investors. Some of these advantages have been listed below:
There have been some cases when organizations came close to default. However, it has never happened until now. It is for this reason that investors who invest in covered bonds are confident that the chances of impairment of their capital are close to zero!
With the increase in regulation, the demand for covered bonds is also increasing rapidly. This is why the market for these bonds is projected to grow at high rates in the future.
Since over a trillion-dollar worth of these bonds have already been issued in the market, there is always an investor who is willing to trade these bonds for cash. This gives investors the ability to enter and exit the market at any time of their choosing.
Even though covered bonds have never seen a default, there are certain disadvantages to this asset class as well. The details have been listed in the article below:
Here, investors have to be aware of the pool of assets as well as the financial condition of the issuer who is issuing the assets. Also, since credit rating is a lagging indicator of credit quality, they cannot rely much on credit rating firms. This complexity is what makes covered bonds difficult to understand for the average investor.
Hence, if a company issues excessively covered bonds, it may witness a significant fall in its credit quality. This could end up increasing the cost of debt. Hence, covered bonds are useful for companies only if they are issuing a small amount of debt.
The bottom line is that covered bonds are a great investment choice for investors who rate safety higher than the growth rate of their investments. Of late, there has been a huge rise in demand particularly from institutional investors.
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