Covered Bonds | CFA Level I Fixed Income

In this section, we’ll summarize the characteristics of asset-backed securities (ABS) and compare them with covered bonds.

Asset-Backed Securities Recap

An ABS is structured so that cash flows from a particular asset or pool of assets are specifically set aside for payments to investors. A firm achieves this by selling assets to a bankruptcy-remote entity called a special purpose vehicle (SPV). If the originating firm goes bankrupt, the assets in the SPV are protected from the firm’s creditors. However, if the underlying assets of the ABS fail to perform, ABS holders have no recourse from the originating firm.

Covered Bonds: Similarities and Differences with ABS

In some European and Asian countries, financial companies issue covered bonds. They are similar to ABS, but the underlying assets (the cover pool) remain on the balance sheet of the originating firm, meaning no SPV is created. Like ABS, cash flows from the assets should flow directly to the covered bondholders.

The cover pool is bankruptcy remote, and special legislation protects the assets from the firm’s creditors, even though they remain on the balance sheet. However, unlike an SPV, covered bonds provide protection to their bondholders. If the assets in the cover pool fail to perform, the originating firm must replace or augment the non-performing assets, ensuring they always provide for the obligations of the covered bond.

This feature is considered a credit enhancement, which usually lowers the required yield on the bonds. And unlike ABS, which are structured with credit tranching to provide different risk-return characteristics, covered bonds are typically structured as a single tranche.

Types of Covered Bonds

Covered bonds may have different provisions in case their issuer defaults:

• Hard-bullet covered bonds – These are in default if the issuer fails to make a scheduled payment.
• Soft-bullet covered bonds – These may postpone the originally scheduled maturity date by up to a year.
• Conditional pass-through covered bonds – These convert to a pass-through bond on the maturity date if any payments remain due.

And that’s our quick introduction to covered bonds.