Covered bonds

Covered bonds are a financial instrument highly commercialized. Spain is in fact the fourth largest issuer within the European Union. In 2018 alone, approximately 280 billion euros were issued in Spain in this product.

What are covered bonds?

Covered bonds are securities issued by credit institutions that are backed by a basket of assets. This basket of assets is called a hedge pool. Usually, this group is made up of mortgage loans or loans to public entities, the former being the most commercialized. Covered bonds are fixed-income securities that enable credit institutions to be financed. Therefore, these entities issue debt that will be bought by investors to whom they will return their principal plus interest. This investor will have a peculiarity, a double recourse for its collection since he has two credit rights. A claim against the entity issuing the bonds and another against the assets that make up the coverage. In bankruptcy terms, the first is an ordinary claim whereas the second one is a special privileged claim. Thus, covered bonds are between senior unsecured debt and asset-backed securities.

As you will see later on in Europe, we are currently in the process of harmonising its regulation.  So far, covered bonds in UE where regulated partially and asymmetrically.  Even though these bonds were defined by UCITS IV Directive, this concept was only established in terms of investment limits. Therefore, depending on the Member State, different names and categories could be found for covered bonds. In Germany, for example, they are named as Jumbo Piandbrief.

Covered bonds in Spain

In Spain they are marketed mainly as mortgage bonds and regional bonds, the latter being guaranteed by public debt. In the case of regional bonds, the credit institution issued a loan to a public administration which it will use as a guarantee. For mortgage bonds, the credit institution will use all the mortgage loans it has taken out as a guarantee. Exceptionally the mortgage bonds with special guarantee are guaranteed only with mortgage loans identified in the title. Mortgage bonds are regulated in Spain by Law 2/1981, of March 25^th, regulating the mortgage market.  This type of product usually has a maturity of between 1 and 5 years, i.e. a medium-term approach.  In Spain, there is also a restriction on their issuers established in the aforementioned legislation. Credit institutions cannot issue bonds for more than 80% of their mortgage loans. The main issuer of this type of covered bond is banks, although there are others such as savings banks.

It is curious that these mortgage-backed bonds were the ones that best survived the financial, and real estate, crisis of 2008. This is because for the investor they represent a very low risk and, therefore, almost a safe return. In return, it allows credit institutions to issue debt and finance themselves, something that was necessary to survive the crisis.

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Security rights in debt refinancing

In this article we will discuss what the usual security rights provided in a debt restructuring process are. Specifically, we will focus on security rights such as the mortgage and the pledge.

What changes are introduced by Directive (EU) 2019/2162?

Since 2018, the European Parliament and the Commission have been considering the creation of an EU regulation for covered bonds. This harmonization has been established by Directive (EU) 2019/2162 on the issuance and public supervision of covered bonds. These bonds are promoted as a way of financing credit institutions because they bring benefits to the real economy. This is because the more liquidity a bank has the better financing conditions it can offer to companies and individuals. The purpose of this Directive is none other than to achieve these benefits while keeping the risk of these products low. For the latter, it creates a European covered bond certificate that will be supervised by a competent state authority.  Initially, however, some banks are not in favor of this rule because it takes away their autonomy over these products.

1. Expands the composition of the package

As regards the coverage package, i.e. the assets that guarantee this product, the directive opens up new possibilities.

Firstly, it allows these assets to be from outside the European Union. In fact, this directive establishes obligations for the European Commission and European Banking Authority. Both are committed to set an equivalence regime by 2024 for foreign countries that issue covered bonds.

Secondly, it allows the use of group covered bonds. These are those whose hedge pool is made up of other covered bonds issued by another entity in their group. It even allows the use of covered bonds from other credit institution outside the same group.

Thirdly, it allows the use of derivative products in the hedge, usually interest rate derivatives. To use this financial instruments this rule requires a minimum conditions. The most remarkable is the fact that the clause of Automatic Early Termination should be removed. This clause is one of the clauses of the ISDA Master Agreement. So, even if the covered bond issuer becomes insolvent, this derivative contract could not be resolved.

The directive allows all this expansion as long as the hedge assets maintain a high credit rating.  In fact, it should have a credit rating of level 1. If this rating diminish to level 2 this hedge assets would not be valid. Exceptionally a hedge pool with level 2 will be allowed in some cases as intra-group covered bonds.

2. Increases control and supervision

On the other hand, it gives the possibility to create a control body of the whole hedge pool. This body will be independent or not from the credit institution and will ensure that the hedge assets do not lose rating. This body will also be independent of the competent authority that will supervise and label these instruments as “European”.

3. Enhanced investor protection

In addition, it introduces a number of requirements to give greater protection to the investor. Firstly, to ensure liquidity through a cushion covering net outflows for the next 180 days. On the other hand, it ensures the guarantee of the hedging assets by establishing it as a privileged credit in its article twelve. Besides, in case on bankruptcy procedures these assets will be separated from the insolvency estate. It establishes also a protection in this case of bankruptcy because bonds ´payments will not be altered.  As MiFID did for other products, it establishes high investor information obligations, in fact this must be provided at least quarterly. Such information must also be available in the issuers’ web page. In the area of bankruptcy, it allows for a second bankruptcy administrator to look after the interests of these privileged credits.

What is the status of its implementation?

The question, however, is how the Member States will adapt the rules in each State. It is a minimum directive which allows each State a certain amount of freedom in its transposition. In Spain, before the beginning of the Covid-19 health crisis, the public consultation phase was opened for its transposition.

Coronavirus crisis situation

European banks have issued 40 billion Euros in covered bonds in two weeks, at the end of March. This is more than half of what was issued by European entities in the 2019 financial year. The point is that in the face of the coronavirus and the instability of the financial market, banks are looking for liquidity.  One way to achieve this liquidity has been the issuance of this financial product. This product is used because, being very low risk, it is usually cheaper and easier to sell. The lower risk of these products lies in the double guarantee they have for the investor. Due to the variations of the current financial market, investors flee to those products that they consider to be of higher quality.  Among these higher quality assets are covered bonds, the latest issued by Deutsche Bank Spain has received the rating of Aa3. However, credit rating companies already estimate that its rating will decline over time. But as this decline does not have a short-term impact, it helps banks to ensure liquidity in the current situation.

In addition, it is remarkable that just before the vast impact of coronavirus in Europe the ECB issued a decision about these bonds. Decision EU 2020/187 concerns the third purchase programme of covered bonds. In fact, in the first week of April this programme had already begun. And at that time had reach over 275 billion of Euros in its purchases.

Conclusions

Covered bonds are essential financial products in situations of financial market instability.  This is because they allow credit institutions to finance themselves and obtain liquidity in times of high difficulty. Moreover, this liquidity translates into a benefit for society indirectly, both for companies and individuals. And, not only does it have benefits for this party, but also for the investor, since it offers a stable return at a very low risk.  For the time being, these bonds continue to be an option used by banks to raise funds during crises. But, we will have to see how they evolve in the next months or years.

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