Covered bonds have been a widely used and broadly accepted funding instrument in Europe since the 18th Century and were amongst the least affected financial products during the global financial crisis. Although not immune to the disruptions, at the peak of the crisis they were the only market-based source of financing. Indeed, they gained visibility and increased importance as issuance volumes rocketed after special stimulus measures were undertaken by the European Central Bank.
Until the very recent policy announcement by the Australian Government that covered bonds would be allowed, Australia was one of only a few developed countries with a banking system that did not issue covered bonds. The recent policy announcement has not yet been legislated, but it is expected that draft legislation will be circulated for comment by the industry in the early months of 2011.
What are covered bonds?
Covered bonds are secured debt instruments issued by a credit institution, either as a single issuance or as part of a program. They are a highly-rated - usually AAA - low risk, interest-bearing product with a maturity that is normally no less than one year and no more than 30 years.
In the event of the issuer’s payment default bondholders have preferential recourse to specified collateral, known as the cover pool. This pool is ring-fenced from the issuer’s other assets and from the claims of its general creditors. If the collateral is not sufficient to satisfy bondholders’ claims, there is additional recourse against the credit institution.
The multiple-recourse nature of covered bonds seeks to ensure that they can withstand any distress experienced by the issuer or caused to the underlying collateral. Indeed, compared with other debt securities, covered bonds can be classified as senior secured debt.
Why are they so popular?
As a consequence of the heightened instability in the global financial markets and deteriorated
prospects for growth, there has been a drastic decrease in the global number of securitisations through the loss of investor confidence. This has severely limited the ability of credit institutions to sell debt to investors.
As a result, investors around the world are looking for alternative investment vehicles that contain increased safeguards and security. Covered bonds have proved to be a popular alternative with their structure directly addressing the failings of securitised products.
There are a number of inherent features of covered bonds that are contributing to investors’ willingness to invest in them. By way of summary, six key features are outlined in Figure 1.
The collateralised asset pool, usually mortgages, remain on the balance sheet of the issuer. This pool of assets secures or covers the bond repayment obligations. Yet it is an investor’s recourse directly to the issuer, and the consequent lack of credit risk transfer, which has the greatest appeal.
The Australian position
Past attempts for Australian Deposit-taking Institutions (ADIs) to issue covered bonds had been halted by the Australian Prudential Regulatory Authority (APRA). APRA has expressed a policy concern that ring-fencing assets for cover pools potentially could leave the remaining asset base of issuing ADIs insufficient to meet liabilities to depositors.
In December 2010 the Australian government announced a new policy that covered bonds would be allowed. After industry consultation it is expected that amendments to the Banking Act 1959 will be proposed early in 2011. The scheme will allow covered bond issuance by local ADIs under a specific legislative regime which has deposit holder protections and caps on covered bond issuance, including through regulatory oversight.
The resilience and stabilising role of the European covered bond market has seen US authorities take specific measures to foster a domestic market of their own. Last March, Republican Scott Garrett introduced comprehensive federal legislation into the House of Representatives in the form of a stand-alone bill - the United States Covered Bond Act of 2010. In July, a revised version of this bill won a favourable vote from the House Financial Services Committee, thereby making it eligible for further consideration and a possible vote by the full House of Representatives.
The need for change
Australian ADIs have proven to be relatively resilient to the GFC, due to the conservative nature of their balance sheets and the general strength of the Australian economy, but they have nevertheless suffered from the rising costs of funds and greatly reduced access to the |global capital markets. At the same time, they have faced increased demands to provide credit and liquidity to clients.
Given the need for ADIs to access alternative and more diversified sources of liquidity - both domestic and foreign - the establishment of a covered bond market in Australia will represent an additional, complementary source of financing. It will help ADIs to diversify their balance sheets and become more competitive. It will result in a stronger, more resilient and stable banking sector, while enhancing Australia’s international standing as a regional financial services hub and global financial centre.