Covered Bonds

Covered bonds are a type of debt securities, which are hybrids of generic secured corporate bonds and asset-backed securities. They possess dual recourse for investors as they get a particular routine payment from the issuer AND have their bonds secured by collateral.

A staple in the European market, covered bonds are gaining prominence in India thanks to a booming lending market. These bonds are generated through securitising a particular strain of loans covered by collateral. Central banks, private banks, and non-banking financial institutions – any firms that lend out loans on collateral can issue covered bonds.

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What are Covered Bonds?

Covered bonds are a hybrid of asset/mortgage-backed and regular company bonds. The extra layer of security that covered bonds provide makes them ideal for retail investors.

Banking and non-banking financing institutions pool multiple loans into packages and issue them as bonds. Public sector loans, vehicle loans, and mortgage loans are some of the most common types of loans bundled & issued as bonds. These loans are bank investment pools that generate a steady cash flow for the lender and investors. A covered bond is generally issued by a special purpose vehicle, a specific entity within a business that ensures bankruptcy remoteness. The issuer transfers the cover pool of assets to the special purpose vehicle and also offers recourse to the covered bondholders alongside the issuing company.

The issuer must make interest payments routinely and the principal payment to the investor when the bond matures. The additional protection is the cover pool of assets associated with a covered bond. In case of any financial calamity, bondholders get recourse from the issuer and bankruptcy-protected recourse from the cover pool of underlying assets related to the loans.

What Makes a Covered Bond Secure?

To the layman or first-time investors, covered bonds may seem somewhat similar to asset-backed securities. However, unlike asset-backed securities, they remain on the issuer’s balance sheet. Thus, bond holders enjoy double recourse- not only do they have a preferential claim over company assets in case of bankruptcy, but they also have access to the underlying cover or investment pool of assets. In addition, investors holding the secured bonds also receive the scheduled interest payouts and the entire principal amount in maturity.

The dual recourse of corporate bond security and access to a dedicated pool of underlying assets makes covered bonds much safer investments than mortgage-backed securities.

Types of Covered Bonds India

  1. Legislative Covered Bonds -A legislative covered bond has legal support from a specific regulatory framework, which aligns with the crucial aspects of covered bond laws. This affects improving the remoteness of instrument bankruptcy. Currently, there are no particular legal frameworks for regulating & governing these bond types in India.

  2. Contractual Covered Bonds – Similar to their legislative counterparts, the only difference is the basis of the bond’s bankruptcy remoteness, which in this case, is based on the features of contractual agreement.

Features of Covered Bonds

  • They provide recourse of two kinds– issuer obligation to bondholder and security from underlying cover pools.

  • A covered bond is a secure investment for investors that guarantees attractive interests and comes with additional security.
  • Covered bond holders have a preferential claim over the issuer’s assets as well as the collateral assets of the cover pool.
  • Special law-based frameworks (legislative covered bonds) or general law-based frameworks (contractual covered bonds) define the essential features of these bonds.
  • It is the issuer or credit institution’s obligation to maintain sufficiency in the cover pool of assets.
  • Despite the low risk, covered bond investments are complicated and demand significant funds from investors. Therefore, they are best suited for major investors such as business organisations and high-net-worth individuals.

Why Invest in Covered Bonds?

Covered bonds are considered much safer than other traditional security instruments. The securitised pool of loans on the issuer’s balance sheet adds an extra layer of security to these bonds. Add the issuer’s obligations towards bondholders, and investors enjoy a dual recourse against bankruptcy. The additional security remains the biggest reason to invest in a covered bond. Furthermore, the interest payouts on covered bonds are substantially high.

Advantages of Covered Bonds for Investors

  • They are safer investment options than most traditional investment instruments, thanks to the dual recourse they offer.

  • High-interest rates of up to 12.75% make them an attractive investment option.
  • Investing in a covered bond is ideal for investors with low-risk tolerance.
  • In India, certain fintech companies have begun to issue covered bonds to retail investors. However, the Reserve Bank of India’s latest rules regarding covered bond transactions ushered in some drastic changes.

Who are the Investors in Covered Bonds?

In India, covered bond investors are generally large institutions and high-net-worth individual investors. Retail investments in covered bonds have not proliferated much in India, and the latest RBI circular on covered bond issuance makes things not conducive for retail investors.

Covered bond holders in the Indian market are:

  • HNI Investors
  • Domestic Central Banks
  • Wealth & Asset Managers
  • Government Pension Funds
  • Bank Treasuries

FAQs

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Yes, they are. The dual recourse against the issuer and the cover pool makes covered bonds safer than both generic secured bonds & asset-backed securities. This makes these instruments ideal for investors with low-risk tolerance.

A covered bond offers high interest payments. And the additional security in the form of a cover pool makes them excellent investment options. Investors get routine interest payments and the entire principal on bond maturity. In addition, in case of insolvency, bondholders have a preferential claim over any liquidation proceeds of the company and access to the collateral pool associated with the bond.

A covered bond is a safer investing idea than ASB or MSB, as both the cover pool and the investor liability remain in the issuer’s balance sheet.

The ideal range of investments for covered bonds is between Rs. 50000 to Rs. 5 lakhs. However, retail investors now have the option to invest in bonds for amounts as low as Rs. 10000.