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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.
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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.
Asset-Backed Securities (ABS) 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.
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:
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.
Till the time there is no legislation,the following
practices can be used:
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.
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
Mr. Neelansh Gupta is a Legal Counsel having extensive in-depth knowledge of various laws. He has completed his graduation in law and has experience in IPR, Taxation and Corporate laws.
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