Covered bonds are much like normal bonds except that they carry an extra level of security ‘cover’. They are generally backed both by the issuer and by a specific pool of assets. The only issuers of covered bonds Australia are the big four banks plus Suncorp-Metway. Banks have typically issued covered bonds at tenors of 5 to 10 years, compared with a norm of 3 to 5 years for their unsecured bonds.
Banks have slowed down their issuance of covered bonds now that their covered bond programmes are maturing, having only been able to issue under these programmes since late 2011. Covered bonds have allowed banks to diversify their investor base and reduce their funding risk. Australian banks’ covered bonds have consistently been rated AAA, which has allowed the banks to attract new funding from investors with AAA mandates. This could also have helped those banks repurchasing their government-guaranteed debt, as the banks were able to offer investors an alternative AAA asset to invest in.
Because the assets backing the bonds are ‘ring-fenced’, easily identifiable and stay on the issuer’s balance sheet, the bonds tend to have a higher credit rating than bonds that are not covered. The quality of the credit rating will still depend on the quality of the pool of loans providing cover for the bond. In the event of the default of an issuer, rather than relying on the winding-up of the company to retrieve their capital, bond holders also have recourse directly to the pool of assets.
From an investor’s perspective, such bonds can be attractive because they are high-quality instruments that offer attractive yields and are often more secure than relying on the credit worthiness of the issuer alone. Covered bonds usually trade at lower yields to corporate debt because of this. However, when corporate bond spreads to government bonds are narrowing, covered bonds might be expected to underperform senior debt as there is less margin to compress.
From an issuer perspective covered bonds can be a low-cost way to expand the business in preference to issuing unsecured debt instruments. The popularity of covered bonds has waned as the popularity of RMBS (Residential Mortgage Back Securities) has grown. RMBS are similar to covered bonds but differs in that RMBS are backed by a pool of mortgages only and are off-balance sheet items for the issuer. In other words, RMBS are not backed by the mortgage provider.