Covered bonds

How does a covered bond work?

A covered bond is a senior bond issued by a bank and backed by a pool of loans. The pool is the cover pool : usually residential or commercial mortgages or loans to the public sector, sometimes ships or aircraft. The loans do not leave the bank. They stay on its balance sheet but are segregated for the covered bondholders, a step called ringfencing .

Investors have dual recourse . They look first to the cover pool. If the pool falls short, they can claim on the bank’s other assets as well. An ABS investor has the pool only.

Covered bond protectionswhy credit risk and yield are lower than comparable ABS

• Dual recourse Memorize claim on the cover pool first, then on the bank's other assets
• Ringfenced cover pool Memorize segregated for covered bondholders, still on the bank's balance sheet
• Dynamic cover pool Memorize a third party monitors it; prepaid and bad loans are replaced
• Overcollateralization Use it pool worth more than the bonds, often a legal minimum
• Loan-to-value criteria Use it loans above the limit must be swapped out
• Redemption regime Memorize softens what happens if the bank misses a payment

The pool is a dynamic cover pool . A third party monitors it, and the bank must replace loans that prepay or stop performing so that cash flows last until maturity. A covered bond usually has a single bond class per pool, with a fixed coupon and a bullet maturity.

Two further tools help investors:

• Overcollateralization : the pool is worth more than the bonds, often by a legal minimum of a few percent.
• Loan-to-value criteria : a mortgage must meet a loan-to-value limit to enter the pool, and a loan that breaches it is swapped for one that qualifies.

$$OC = \frac{\text{Pool}}{\text{Bonds}} - 1$$

Exam tip Overcollateralization is measured against the bonds, not against the pool. Divide by the face value of the bonds.

What happens if the bank misses a payment?

Memorize

If the bank defaults, a redemption regime lines the bond’s cash flows up with the original schedule as closely as it can.

If the bank misses the scheduled paymentthe regime sets what happens next

• Hard bullet Memorize default is triggered and payments accelerate
• Soft bullet Memorize default and acceleration wait for a new final maturity, up to about a year later
• Conditional pass-through Memorize after the original maturity it turns into a pass-through paying as the pool pays

A hard-bullet covered bond defaults as soon as a payment is not made on schedule, and payments accelerate. A soft-bullet covered bond delays default and acceleration until a new final maturity, usually up to a year after the original one. A conditional pass-through covered bond turns into a pass-through security after the original maturity if the bond has not been repaid, paying investors as the pool pays.

How do covered bonds differ from ABS?

	Covered bond	ABS
Assets	Stay on the bank’s balance sheet	Sold to a bankruptcy-remote special purpose entity (SPE)
Recourse	Pool and the bank (dual)	Pool only
Pool	Dynamic: the bank must replace bad or prepaid loans	No duty to replace bad loans; any additions follow the deal’s set rules
Classes	Usually one	Usually several
Typical coupon	Fixed, bullet maturity	Often floating, passes through prepayments
Credit risk and yield	Lower	Higher
Capital relief for the bank	No	Yes

The two serve different purposes. A covered bond is long-term bank funding that costs less than an unsecured bond, because the pool stands behind the bank’s own promise to pay; the buyer is lending to the bank. An ABS buyer takes on the credit risk of the loans themselves, and is paid a higher return for it. Because the bank stays on the hook, covered bonds have remained a stable source of funding, and they usually carry lower credit risk and lower yields than otherwise similar ABS.

Go deeper Green covered bonds

A green covered bond is backed by a pool of mortgages on buildings that meet a green certification, so the proceeds support energy-efficient housing. The structure is the same as any covered bond: the same dual recourse, dynamic pool and redemption regime. Only the eligibility rules for the pool change.

Go deeper Two tools for two jobs

Banks use the two tools for different jobs. A covered bond is cheap bank funding with the pool as an extra promise. An ABS moves loans and their risk to investors. A bank can use both, and investors choose between them on how much credit risk they want.