Asset-backed securities have become famous all over the world in the past few years.

The largest market for asset-backed securities was in the United States of America. The sub-prime mortgage exposed the flaws inherent in the process of issuance of asset-backed securities.

The world had been looking for an alternative to asset-backed securities. This is where covered bonds have started gaining popularity.

Covered bonds are a distinct type of fixed income instrument which are somewhat similar to asset-backed securities. These types of bonds earlier originated in Germany. However, over time, they have become quite popular in most parts of the world. The changed Basel norms have created a huge demand for these covered bonds.

In this article, we will have a closer look at what covered bonds are as well as the advantages and disadvantages of using covered bonds.

What are Covered Bonds?

Covered bonds are similar to asset-backed securities in the sense that they too are created after the securitization of a pool of loans or assets. However, the defining feature of covered bonds is the fact that investors in these bonds have “dual recourse”. This means that in the event of a default, the investors would first have a claim on underlying assets which were collateralized to issue these securities.

These securities are ring-fenced so that the financial health of the parent company does not impact them. Hence, in the event of a default, first, these assets will be sold to make good the losses.

However, if the assets are not enough to make good all the losses, then the investors will also have an unconditional claim on the issuer of these securities. This means that, unlike asset-backed securities, these bonds continue to stay on the books of the organization which issued them.

The dual recourse feature makes these bonds amongst the safest in the world. Hence, they are virtually at the very top of the fixed income structure.

Even though such types of bonds have existed in Germany for almost a century, they have risen in popularity in the recent past. At present, covered bonds are one of the highest issued bonds in the world. It is estimated that there is more than $1.1 trillion worth of covered bonds outstanding in the world.

Advantages of Covered Bonds

Covered bonds provide some distinct advantages to investors. Some of these advantages have been listed below:

1. Safest Asset Class: It is important to note that covered bonds are undoubtedly the safest asset class in the entire fixed-income securities market. This can be said with confidence because there has never been even a single default of any covered bonds in the entire world.

   There have been some cases when organizations came close to default. However, it has never happened until now. It is for this reason that investors who invest in covered bonds are confident that the chances of impairment of their capital are close to zero!

2. Regulatory Benefits: Since covered bonds are so safe, there are certain regulatory benefits that arise from holding them. The Basel III norms incentivize the holding of covered bonds which is why banks and financial institutions around the world are making a beeline for these assets.

   With the increase in regulation, the demand for covered bonds is also increasing rapidly. This is why the market for these bonds is projected to grow at high rates in the future.

3. High Liquidity: From an investor’s point of view, these bonds also provide a lot of liquidity.

   Since over a trillion-dollar worth of these bonds have already been issued in the market, there is always an investor who is willing to trade these bonds for cash. This gives investors the ability to enter and exit the market at any time of their choosing.

4. Lower Cost of Funds: The biggest advantage of these bonds is that the overall cost of funds is lowered for the issuer. Since the probability of default is almost negligible, investors are willing to accept a much smaller coupon payment. This low cost of funds is another reason why companies are increasingly issuing covered bonds.

Disadvantages of Covered Bonds

Even though covered bonds have never seen a default, there are certain disadvantages to this asset class as well. The details have been listed in the article below:

• Complexity: The price of covered bonds is governed by a lot of factors. For instance, in the case of normal asset-backed securities, investors only have to analyze the financial condition of the pool of assets backing the bonds.

  Here, investors have to be aware of the pool of assets as well as the financial condition of the issuer who is issuing the assets. Also, since credit rating is a lagging indicator of credit quality, they cannot rely much on credit rating firms. This complexity is what makes covered bonds difficult to understand for the average investor.

• Deterioration in Credit Ratings: The problem with covered bonds is that any company can only underwrite a limited quantity of these bonds. This is because every bond issue is considered to be a liability of the company even though there is an asset pool backing it.

  Hence, if a company issues excessively covered bonds, it may witness a significant fall in its credit quality. This could end up increasing the cost of debt. Hence, covered bonds are useful for companies only if they are issuing a small amount of debt.

• Low Yields: Covered bonds tend to provide abysmally small yields. This should come as no surprise since we have already mentioned above that they are the safest fixed-income security product and hence issuers do not feel any compulsion to offer high returns. As a result, investors do not witness any significant appreciation in their capital investment.

• Difficult to Sell in Boom Periods: Covered bonds witness huge demands during recession periods when people are afraid of mass defaults happening. During periods of high economic activity, it is difficult to sell these bonds to raise more money.

The bottom line is that covered bonds are a great investment choice for investors who rate safety higher than the growth rate of their investments. Of late, there has been a huge rise in demand particularly from institutional investors.