Monday 13 December 2010 by FIIG Research Legacy

The Treasurer Uncovers Covered Bonds

Amongst Treasurer Wayne Swann's announcement on banking reforms over the weekend is the prospect of the Government allowing financial institutions to use covered bonds as a source of funding

Covered bonds have been a popular source of funding in Europe, North America and New Zealand for some time, however the Australian Banking Act, as it currently exists, has prevented a covered bond market in Australia.

The issue for the Australian market is the ranking of covered bond holders and Depositors in the context of the Banking Act. The Government has highlighted its intention to release draft amendments to the Banking Act which would allow the sale of covered bonds during the first sitting of Parliament in 2011. Restrictions on the amount of covered bonds being able to be offered by a financial institution are also expected, with a limit of 5% of total assets mooted.

What is a Covered Bond?

Covered bonds are debt securities issued by a bank or financial institution and backed by the cash flows from a specific group of loans. In general, covered bonds are backed by either mortgages or public sector loans (though in the Australian context, public sector loans are unlikely to form part of the securities).
In this way, covered bonds are similar to mortgage or asset-backed securities (ABS) however there's one big difference, covered bonds must remain on the balance sheet of the issuing bank. Most ABS are “off-balance sheet” transactions conducted through special purpose vehicles, which effectively removes the risk associated with the loans from the financial institution. By keeping the risk of the mortgages on the financial institution's balance sheet, the issuer is incentivised to maintain the credit quality of the covered bonds as it maintains the obligation to pay.

If the issuing financial institution becomes insolvent, the covered bondholders funds are secured by the underlying mortgages of the loan pool. This added level of protection for bondholders helps underpin the covered bond market.

Why Would I Invest in Covered Bonds?

The key driver of covered bond investment is the higher returns available for bonds of very high credit quality. In general, the structure of the pool and the quality of the mortgages underpinning a covered bond (combined with the issuing financial institution's rating) results in very strong credit ratings, typically double- or triple-A.

Bonds of this quality are usually limited to government bonds, which typically would have lower yields than those available to covered bond investors.

Covered bonds also offer considerable diversification benefits for investors seeking a low risk portfolio whilst the security over the mortgage pool helps protect investors from the default risk of the issuing institution.

Why Do Issuers Offer Covered Bonds?

The issue of covered bonds gives financial institutions the ability to access the value of the mortgages on their balance sheet. The higher credit ratings able to be achieved by a covered bonds structure allows institutions to access cheaper funding than what might otherwise be available through the conventional unsecured bond market.

Finally, the financial crisis has highlighted the need for financial institutions to diversify their funding sources. The highly rated nature of the covered bond structure allows financial institutions to access investors who may otherwise be unavailable to them.

Is There a Market in Australia for Covered Bonds?

Foreign financial institutions have previously issued covered bonds into the Australian market showing that there is investor appetite for such products.

The ability of domestic financial institutions to offer covered bonds should see this market expand, and we view any action which expands the Australian fixed income through quality issues to be a positive.