Covered bonds are debt instruments secured by a cover pool of mortgage loans (with property as collateral) or public-sector debt to which investors have a preferential claim in the event of default. In covered bonds, dual recourse means that bondholders have two sources of repayment: the issuer of the bond (a bank or building society), and the cover pool of assets that the bond is backed by. If the issuer defaults, bondholders have recourse to the cover pool, which is regularly monitored to ensure it is more than sufficient to cover the outstanding debt. Understanding the issuer's creditworthiness remains a key feature of analysing covered bonds. However, knowing the quality of the cover pool is also important, as it determines the strength of the bond's dual recourse feature.
There are several key factors that are considered in a covered bond pool analysis, including the size and diversity of the asset pool, the quality of the individual assets, the level of overcollateralization (collateral that is worth more than enough to cover potential losses in cases of default), as well as modest loan-to-value (house prices > mortgage outstanding).
Benefits of having covered bonds in your investment portfolio
Covered bonds are issued by, or backed by, major depository financial institutions, which are regulated entities subject to high levels of supervision. Such involvement by regulators, both at the issuer level and in enacting legislation governing statutory covered bonds, underpins the credit quality of covered bonds. As a result, most UK covered bonds are rated AAA.
Following the implementation of the Bank Recovery and Resolution Directive (BRRD) in Europe, many unsecured liabilities of financial institutions became subject to "bail-in" requirements. In the event of a default the unsecured depositors will recapitalise the bank. Secured debt obligations, including covered bonds, are exempt from this treatment under the BRRD.
Covered bonds are regarded favourably by investors because they produce a yield in excess of the risk free rate and offer greater diversification than many debt instruments with comparable risk exposure, such as government bonds. In the recent rising rate environment, floating rate notes have been particularly popular.
Overall, the analysis of a covered bond is an important tool for investors to assess their risk profile and make informed investment decisions. It provides information about the quality and risk of the underlying assets in the pool, which is critical for investors to understand the potential returns and risks of their investment. As we have all witnessed first-hand, The Great Financial Crisis of 2007-2008 was linked to single recourse asset-backed securities, where poor quality of underlying assets and a drop in housing prices led to large losses for investors and institutions, causing a crisis in the market. Since then, regulators have increased capital requirements and improved the quality of underlying assets to reduce the risk of another crisis.
The relative safety and stability of covered bonds compared to other types of bonds may make them an attractive option for investors seeking a relatively safe investment.
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