Taking cover – how covered bonds can shield in a crisis

Fixed income has become a minefield for investors since 2010, as eurozone sovereign debt and related bank bonds rose and fell sharply during the bloc’s financial crisis.

Some peripheral sovereign debt fell by up to 40%. Spreads over ‘risk-free’ on vanilla bonds from the banking sectors widened sharply.

Covered bonds may be one way to reduce the risk of getting exposure to the broad asset class, suggests SEB Asset Management, which has more than 10 people managing about €1bn in the class.

The well-known Pfandbrief portion of the covered bond class was born from of a crisis – Prussian rulers introduced them in the 1700s, to ease a credit squeeze after the Seven Years’ War.

The asset class remains most closely associated with Europe, where the main portion of the global volume is issued, and it showed its worth to investors in a more recent ‘credit crunch’ after Lehman Brothers collapsed in 2008.

Covered bonds typically fell in value by 0.2%, at most, in the aftermath, whereas vanilla, uncovered bonds from many banks fell much further. In addition, covered bond markets stayed open, though prices had fallen, whereas some structured credit markets stopped functioning.

Issued by banks, covered bonds have an extra ‘safety cushion’ of being backed by real assets, in the ‘cover pool’. These are often, but not always, mortgaged property. Public loans, and other hard assets can also be underlying.

The fact covered bonds are ‘asset-backed’ might lead investors to confuse them with the toxic ABS credit instruments, based on lower quality house loans, that collapsed in America from 2007.

But covered bonds differ from such structured credit in significant ways.

First, the pool of underlying assets sits on the issuer’s balance sheet, in contrast to the off-balance-sheet nature of some underpinning assets for CDOs, SIVs, CLOs, and other structured credit.

Covered bond pool assets are therefore included in corporate results. Therefore it is in the interest of bond-issuing banks – already under pressure from Basel III, Solvency II and now the European Banking Authority to maintain the quality of balance sheet assets – to ensure quality of assets behind their covered bonds.

 

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