Why do investors like covered bonds?
What is it about covered bonds that investors like? Even U.S. investors who have plenty of other fixed income investment opportunities. In Europe there is more than €2 trillion in covered bonds outstanding. Even in the U.S., which has no statute to enable its banks to issue covered bonds, there is $150 billion of covered bonds outstanding.
What is it about these bonds and who is buying them?
You can find out who the investors are at The Cover or The Covered Bond Report. Both publications provide a breakdown of type and location of investors by offering. And what the data shows is that banks and central banks are between 50% and 80% of the investors, depending on the offering. The remainder goes to funds, asset managers and insurance companies. While not a distinct class of investors, the composition is quite different from the class of investors in bank senior debt or securitizations. Why? And why central banks? Aside from QE, of course.
The answer lies in the nature of covered bonds. Covered bonds are a different kind of investment. They are more than senior bank debt because there is recourse to the cover pool. They are more than securitization because there is recourse to the issuing bank. Covered bonds are a dual recourse instrument, which raises an investor's confidence in their safety. Importantly, in Europe covered bonds are not subject to bail-in, while senior debt is.
And in Europe, covered bonds receive favorable capital treatment under the bank capital rules, attracting only half the capital that a senior bond from the same institution would attract. But that only makes sense given the dual recourse nature of covered bonds compared to senior debt. And of course central banks are not subject to the capital rules anyway.
So what appears to attract banks and central banks and other investors is the high level of safety with covered bonds combined with a yield that exceeds similarly rated sovereign debt. And covered bonds have a similar risk profile - no defaults in 250 years. Quite a record.
There are other details about covered bonds that are also considered important.
Covered bonds are issued by regulated financial institutions and the covered bond programs of the institutions are separately regulated.
The quality of the assets in a cover pool is high and subject to regulation. Any assets that default or become delinquent must be replaced on a monthly basis. The bank has 100% "skin-in-the-game."
The bonds are simple, bullet pay instruments with either a fixed or floating rate. If the issuing bank were to become insolvent, the assets in the cover pool are intended to continue payments on the bonds through their maturity. No pre-payment risk.
Each series of covered bonds is a single class, so there is no complex class structure and complex payment waterfall to analyze. The credit analysis is primarily an analysis of the strength of the issuing bank and for this there is a huge community of analysts to assist an investor and a wealth of analytical experience covering more than 100 years of corporate credit analysis. The lack of experience and analytical talent was one of the prime failings of securitizations leading up to the crisis.
So what's not to like? A risk profile like sovereign bonds and a better yield. No wonder there is a €2 trillion market. But will the United States Congress like them?
Why not covered bonds?
Why not pass legislation for covered bonds in the United States? It is easy to do and there is basically no cost to the Treasury. In 2011, covered bond legislation passed the House Financial Services Committee by a vote of 44 to 7, a very strong bi-partisan vote. The only dissenters were hoping to implement provisions requested by the FDIC that were rejected by the majority. The dissenters were unable to retain even members from their own party on the final vote. Probably more than any other development, this demonstrates that covered bonds are not a partisan concept, they are not divisive and they have broad support.
Covered bonds will bring private funding to residential mortgage loans, but there is no good reason that passage of covered bond legislation should be tied to GSE reform. There is nothing about covered bonds that would implicate GSE reform, except that by bringing private funding to the market they could reduce the dominate role of the GSEs. And there is no credible evidence that either party in Congress believes that a continued dominate role for the GSEs is a policy mandate.
An unlike securitization of residential mortgage loans, no concerted effort is needed to get investors to participate. Investors are wary of residential mortgage securitization as a result of the financial crisis, which was precipitated by mortgage securitization. There are many efforts underway to convince investors to return to the RMBS market. Covered bonds carry no such baggage. Covered bonds have been readily sold to U.S. markets since 2010 and investors remain eager for more.
Covered bonds are more transparent to regulators.
Covered bonds are a simpler investment analysis for investors.
Covered bonds are proven financing technology with worldwide acceptance.
Covered bonds are friendlier to mortgage borrowers because the originator retains the right to modify loans to assist borrowers in working out difficult loans.
What’s to lose? Maybe covered bonds could develop into a vibrant private sector funding alternative for residential mortgage loans. If not, no loss. And no cost. But if it works, it’s a plus all around.