A Little On Covered Bonds

Covered Bonds sounds much better than the dreaded sounding Asset Backed Securities (ABS) that has been blamed for the financial crisis of 2008 even though they are nearly the same thing.

A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or “covers” the bond if the originator (usually a financial institution) becomes insolvent. These assets act as additional credit cover; they do not have any bearing on the contractual cash flow to the investor, as is the case with Securitized assets.

The investor has recourse against the issuer and the collateral, sometimes known as “dual recourse.” https://en.wikipedia.org/wiki/Covered_bond

Because of this, covered bonds are usually safer than senior, unsecured debt of the issuer although it depends on the quality of assets pooled for the issuer.

The main difference between the covered bond and the ABS would be that the assets remain on the bank’s balance sheets while ABS’s were usually taken off the balance sheet and put into a special purpose vehicle (SPV).

Assets – anything ranging from loans to mortgages to receivables including investments.

The financial crisis came about when those ABS’s started souring despite some of their investment grade ratings as banks packaged sub-prime loans into those securities, selling to them to street, possibly misrepresenting to clients the risks involved.

Covered bonds came about after the crisis struck because banks outside the US had to find another name for what they were selling and ABS is still considered a taboo word.

Covered bonds are also mostly issued by banks or such like entities because the nature of the issuance process would help bolster capital adequacy which other industries are not bound to uphold. Thus it would not make sense for say Singtel to issue covered bonds because it does not help their balance sheet in any way.

Singapore’s DBS bank has become the first bank to launch a US$10 bio covered bond issuance programme. http://www.channelnewsasia.com/news/business/singapore/dbs-launches-singapore-s/1921194.html

Why now ?

Well, Singapore banks really do not have a need to improve their balance sheets with such issuances because they have more than adequate capital coverage.

Yet, Singapore is a little late in the covered bond game and there is an urgent need to stake their place in the global markets especially in the global stage of “respectable issuers”.

Yes, for only respectable issuers qualify to issue covered bonds mainly because no discerning covered bond investor would consider for instance, buying covered bonds out of any EM bank. In addition, most EM banks are not bound by the strict regulations of Basel 3 (going 4).

Covered Bonds Investors- usually entities that have a need for highly rated instruments as part of their investment mandate. These investors are least yield hungry and are concerned with capital protection. They could include banks, central banks and sovereign wealth funds as well as mutual and pension funds.

In any case, the returns from buying covered bonds are justified, in the case of banks, over, for instance, a higher yielding corporate bond because the capital usage is exceeding low compared to buying lower rated papers.

What Sort of Returns To Expect ?

I did some rough maths and found some over 400 covered bonds issued this year, mostly fixed rate and with an average duration of 7 years, mostly denominated in EUR. The average yield is just under 1%.

DBS Bank’s Covered Bonds

I read that the bonds will be backed by mortgage loans out of Singapore and have been rated AAA by Fitch.

The currency of issuance will be either the EUR or USD because those are the main currencies that covered bond investors seek.

How it Matters to You !

1. Do not expect your mortgage rate to be reduced even if your mortgage is included in the pool !

2. You will not be able to find out anyway.

3. Most retail investors would be uninterested in this safe instrument.

4. There is a chance that if things turn pear shaped, your mortgage may not belong to DBS anymore although that is slim even though it happened in the US for those ABS deals. That is because “The Monetary Authority of Singapore (MAS) said earlier this month that regardless of the structure adopted for issuing covered bonds, banks must provide legal confirmation that “cover pool” assets are ring-fenced beyond creditors’ reach, even during insolvency.” Thus, if the “pool” is sold, then there goes.

5. This has never happened in the 100 year history of covered bonds in Europe.

6. A covered bond is the opposite end of the spectrum to the CoCo bond which would appeal to retail investors much more. https://tradehaven.net/market/bond-focus-one-mans-coco-is-another-mans-junk/

Thus it would be reasonable to expect CoCos next ?