Covered Bonds: Everything an Investor Should Know

Covered bonds are fixed-income debt securities and they are investment options issued by credit institutions like banks and NBFCs against a cover pool as collateral.

Covered bonds are backed by cash generated from an underlying investment pool. Banks or NBFCs buy substantial cash-generating investments, combine them, and issue bonds supported by the pooled investments’ money. This pool is called a cover pool and it is either made up of mortgages or public-sector loans.

In that sense, covered bonds generate cash flow for investors the same way as asset-backed securities.

As an investor puts their money in a covered bond, their money is secured against a two layer security blanket. In case a company defaults, the investors get the proposed return amount via the collateral cover pool pledged against the bond. This makes covered bonds a high risk- high return investment option. 

 

History of Covered Bonds

history-covered-bond

As per the history of financial instruments go, the first covered bond was issued more than 250 years ago.  In fact, the very first covered bond was issued during the reign of Friedrich the Great to help rebuild Prussia after the impact of the Seven Years’ War. It was used to fund mortgages and other public assets. 

In 1988, the European Union (EU) issued guidelines for covered bond transactions. 

Here, bond market investors were allowed the liberty of putting more of their assets than was previously allowed. In September 2007, Washington Mutual became the first U.S. bank to issue euro-based covered bonds.

Security Aspect in Covered Bonds

The loans made with the investments received in lieu of a covered bond stays on the balance sheet of the bond issuer.

Covered bonds are more secured that other bonds, because an SPV or a special purpose vehicle is present. But what does this SPV do?

An SPV is formed in order to minimise the financial risk that comes with investing in a bond.

Let us explain, suppose an NBFC issues a covered bond worth Rs. 20 crores and this is secured by Rs. 25 crores worth of vehicles loans (which act as a collateral). Here, the NBFC combines the loan pool worth Rs. 25 crores and sells them to the SPV. And this SPV is managed by a trustee.

An SPV functions as a separate entity and therefore, even if the company goes bankrupt, the SPV will be obligated to repay it’s investors.

Covered Bonds Different V/s Mortgage Backed Securities

Covered bond holders and other fixed income debt security holders have recourse over a portfolio of loans secured by property mortgages. However the purpose, structure and risks are fundamentally different for both the issuer and investor. 

Mortgage backed securities are issued by a special purpose entity. It is an investment wherein the asset is secured by a mortgage. 

A mortage is basically a loan which is sanctioned against a housing property or commercial property. Here, the lender keeps the asset, until the borrower repays the money.

Investors in MBS receive periodic payments similar to bond coupon payments. The bank handles the loans and then sells them at a discount to be packaged as mortgage backed securities to investors as a type of collateralized bond.

For the investor, an MBS is as safe as mortgage loans that back it up.

Covered bonds are issued by credit institutions and are backed by a cover pool that remains on the issuer’s balance sheet. Investors enjoy a dual recourse, both over the issuer – with whom the obligation to pay lies – and over the covered pool and  all its cash flows in case of issuer’s insolvency.

In case of defaults, investors can choose to either liquidate the cover pool by selling it to another entity or to continue receiving coupons from cash generated by the cover pool.

 Covered BondsMortgage Backed Securities
IssuerBanks and NBFCsSpecial Purpose Entity
Interest PayoutPeriodic Coupon PaymentsCoupon Payments
SecurityCover Pool of CollateralsMortgage Loans
   

FDs V/s Covered Bonds

Fixed DepositCovered bonds
In case of a fixed deposit, the money lended to an RBI-regulated bank (the investor is bein g referred as the lender here)in case of covered bonds, NBFCs get the money and the returns solely depend on the repayment from borrowers. Since the risk profile is high, the returns are higher in case of covered bonds,
Banks have a deposit insurance for the money they receive via FDs that ranges upto INR 5 lakh per account holdercovered bonds have no deposit insurance.
if an FD-issuer bank defaults, both the bank and the depositors are generally bailed out by the banking regulator brokering mergers.There is no RBI interference if a covered bond issuing NBFC defaults
An SPV is not set up for fixed depositAn SPV is set up for covered bonds. Therefore, in rare cases, if the company defaults, investors are paid by the trustee who manages this SPV

How are Covered Bonds Taxed in India?

When an investor buys a covered bond, their income from interest earned is taxed at their slab rate. 

However, if a covered bond features a market linked debenture, investors will pay 10% tax if they hold it for over 12 months because it is counted as a capital gain.

This tax is lower than the regular tax on income from interest. For this simple reason, many covered bonds come with a call option that ranges beyond 12  months.

Who Should Invest in Covered Bonds?

The recent surge in the popularity of covered bonds is due to the low interest yields from debt investments. Covered bonds are competing strongly against other fixed-income debt investments in spite of the higher credit risk they pose.

Anyone looking to accrue high returns in the form of fixed income and doesn’t really mind the high risk quotient should ideally invest in covered bonds.

An investor should be wary of the quality of the issuer. It’s best to research the credibility of the issuing NBFC and its loan appraisal capability when choosing a covered bond to invest. A high-quality issuer reduces the investment risk involved.

Happy Winting!

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