Explaining different aspects of Covered Bonds

Neelansh Gupta

28 Aug, 2020

A bond is an instrument via which the investors lend money to an entity (corporate or government) and earn income from this investment. Covered Bonds are secure bonds that are collateralized against a pool of assets assuring the investor recovery of the invested funds, in case there is a failure on part of the borrower. The covered bonds are shown on the consolidated balance sheet of the borrower with a certain capital charge.

How Covered Bonds came into existence?

In Europe, covered bond has existed for around two centuries now. These were first issued in the Prussian Empire to aid in the funding of the seven years’ war. Covered bonds became even more popular during the European debt crisis since at the time investors were not willing to invest in unsecured bonds issued by the banks. Covered bond had a higher credit rating and hence, the investors would be lured to invest in them.

In some countries, investment in covered bond is not allowed. For instance, the United States of America has a no covered bond legislation since covered bond decrease the asset pool of an organization. This could affect the credit rights and the claim of the primary creditors, who rank first when it comes to winding up.

Covered bonds are the most popular in Europe, Japan, South Korea, New Zealand, Australia, and there is a growing potential for them in emerging economies of Asia and Latin America.

Characteristics of Covered Bonds

• It is a debt instrument backed by assets and is secured by a pool of high-quality assets.
• It carries a fixed rate of interest and is a low-risk instrument.
• Maturity period ranges between 1 to 30 years.
• The backed-up assets and credit risk are shown on the balance sheet of the issuer.
• The extra cover pool of assets provided for safeguarding the interest of investors in case of insolvency of the issuer.
• The cash flow of the issuer is used to pay interest to the holders of the covered bond and the pool of assets is used as collateral for security against insolvency of the issuer.

Covered Bonds and Asset-Backed Securities

Asset-Backed Securities (ABS^[1]) are financial instruments whose value is derived from the pool of assets that they are collateralized with. Covered Bond and ASB are similar as both are fixed-income debt instruments. In both, the investors have recourse to pool of assets in case the issuer becomes insolvent. Special Purpose Vehicle is used for both to identify the assets that are covered in the asset pool.

The key difference between Covered Bond and ABS is that issuer of ABS is not required to replace assets that default or mature on the balance sheet, which is required in the case of covered bonds.

What are the main rights of Investors in Covered Bonds?

• The covered bondholders have a priority claim against a dedicated pool of collateral (assets) or the proceeds of these assets.
• The investors have full recourse to the issuer.
• There isan additional dynamic pool of collateral that backs up the covered bonds, to secure the funds of the investors.

Who are the Investors in Covered Bonds?

The investors in covered bond can range from small private investors to large institutional ones. Mostly investors who are looking for long maturity periods and low risk invest in covered bonds. The investors in covered banks could be:

• Central Banks
• Pension Funds
• Bank Treasuries
• Asset Managers
• Insurance Companies

Legislative Framework for Covered Bonds in India

A specific law governing the issuance of covered bond in India is not present. Hence, the interim solution for the same isa contractual arrangement under the general law of the country. Till the time specific legislation pertaining to covered bond is passed, the issuance of covered bonds can be governed under the general law on the basis of contractual agreement between the issuer and the investor. Hence, the provisions of the Contract Act, 1872 would be attracted in this case of agreement.

Best Practice in relation to Covered Bonds

Till the time there is no legislation,the following practices can be used:

• Uniformity in all the procedural aspects by all the issuers. For this, certain standards can be set in the financial market.
• Use of similar templates when making documents for issuance of covered bonds. This would make the recognition and application of regulations pertaining to covered bonds easier.
• A covered bond model with a Special Purpose Vehicle (SPV) can be issued.
• There should be standard rules in relation to SPV, registration with SEBI, maturity period, regulatory authorization, requirements for lending institutions, collateral, security, over-collateralization, disclosure requirements, and other related factors.

Introducing Regulatory Framework for Covered Bond in India

The National Housing Bank in its Working Group had recommended “Covered Bonds” as one of the measures in order to strengthen the link between the Indian capital market and housing finance sector.

• As per the report of the Working Group, a consultation paper had been issued which gave an outline of the proposal for issuance of Covered Bond by the Housing Finance Corporations. The proposal which contained the draft guidelines was also discussed with the Reserve Bank of India (RBI), whereby it was suggested that the Banks would act as Investors/Issuers in Covered Bonds.
• The introduction of covered Bonds has been welcomed by the RBI as it would give new ways of funding in the financial markets in India. However, it has been highlighted that there isa need of legal precision and risk management to effectively issue covered bonds in the market.
•  SEBI has also given its confirmation in regards to covered bonds that they would fall within the purview of “Bonds” as mentioned in Section 2(h)(i) of the Securities Contracts (Regulations) Act, 1956.

Conclusion

It is clear now that the Indian financial market is ready for the issuance of covered bond. The introduction of this new non-dent instrument would open new avenues of investment in the country and since there is hardly any risk attached to it, the investment in the covered bonds is expected to be quite high. Clear legislation on the same would open doors to major growth in our economy.

Read our article:What is the Future of Capital Market in India