This covered bonds primer provides a comprehensive guide to the fundamentals and key features of the product.

Let's start with an obvious question…

What Is A Covered Bond?

A covered bond is a senior secured debt instrument secured by a pool of assets, such as mortgage or public sector loans. As long as the issuer is solvent, it is obliged to repay its covered bonds in full on their scheduled maturity dates. If the issuer defaults, the proceeds from the cover pool assets will be used to repay the bonds.

Covered bonds were first introduced in Prussia in 1769 by Frederick the Great, and in Denmark in 1797. France issued the first "obligations foncieres" in 1852. Despite such a long history, it was not until the end of the 20th century that the size and geographic scope of this market broadened considerably, boosted by the introduction of "jumbo" covered bonds in 1995, the introduction of the euro in 1999, and the approval of dedicated legislative frameworks in a number of new countries.

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In the EU, covered bonds are also defined in the Covered Bond Directive, which was finalized in November 2019 and had to be transposed into member states' national legislation by July 2022, and in the amendments of Article 129(1) of the Capital Requirements Regulation (see the "The Regulatory Landscape" section).

While at the beginning of the century more than 90% of outstanding covered bonds were still issued out of Germany, Denmark and France, their share had decreased to about 40% by 2022.

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Covered Bonds Versus Securitization

Investors' recourse to the issuer and the consequent lack of risk transfer is the main difference between covered bonds and asset-backed securities, such as residential mortgage-backed securities (RMBS). Since in covered bonds the credit risk of the underlying asset pool remains with the originator, it has a greater incentive to manage the assets prudently. Covered bond programs have dynamic cover pools, and assets that repay or which are no longer eligible are typically replaced. By contrast, in RMBS the pool is generally static and assets are not replaced. Finally, covered bonds tend to have bullet maturities, while in most RMBS, principal payments depend on the timing of principal collections on the asset pool, which are transferred to investors as they are received.

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What Are The Benefits Of Covered Bonds?

Covered bonds offer significant benefits to issuers and investors, which explain their popularity.

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Covered Bond Program Structures

Legislation-enabled and structured covered bonds

Initially banks only issued covered bonds in accordance with a dedicated legal framework (legislation-enabled covered bonds). The legal framework would define the covered bond programs' main characteristics, such as eligible assets, minimum overcollateralization, and monitoring.

From 2003, issuers in certain countries without domestic covered bond legislation, such as the U.K. and the Netherlands, established programs that replicated the main features of legislation-enabled covered bonds by means of contractual arrangements: so-called structured covered bond programs. Issuers also sometimes preferred contractual arrangements to gain greater flexibility outside of an established legal framework.

The legal framework, contractual provisions, or a combination of the two need to effectively isolate the cover pool assets for the benefit of covered bondholders, so that covered bond payments continue on their scheduled maturity dates. Depending on the provisions of the national covered bond legislation, this isolation can be achieved by setting up an "on-balance sheet" covered bond program or through an "off-balance sheet" program.

In "on-balance sheet" programs, the segregation is achieved on the issuer's balance sheet or by the issuer setting up a distinct subsidiary to hold the cover pool assets (specialist bank model). Covered bond markets with this structure include Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Korea, Luxemburg, Norway Portugal, Spain, and Sweden.

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In "off-balance sheet" programs, the cover pool is isolated in a special purpose-entity (SPE). Structured covered bond programs are typically set up in this way. However, there are instances of legislation-enabled covered bonds that use the "off-balance sheet" structure, such as in Italy. Markets setting up SPEs include Australia, Canada, Italy, the Netherlands, New Zealand, Singapore, Switzerland, and the U.K.

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Participants

Various parties are involved in the effective functioning of covered bond programs, with roles ranging from the origination of cover pool assets to the repayment of the covered bonds. The number and functions of the parties may vary by program.

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Maturity Structures

As long as the issuer is solvent, it must fully repay its covered bonds on their scheduled maturity dates. If the issuer is insolvent, a cover pool administrator will use the proceeds from the cover pool assets to repay the covered bonds.

In a traditional "hard bullet" structure, the pool administrator may need to liquidate collateral to repay the bonds on time, on their scheduled maturity dates. By contrast, in a "soft bullet" structure, the pool administrator can extend the maturity date, typically by up to a year, before the covered bonds become due and payable. This postpones the liquidation of the assets and can help mitigate the risk of a large "forced sale" discount.

Conditional pass-through (CPT) structures typically switch to a pass-through redemption profile after an issuer insolvency, when either the assets in the pool offer insufficient funds to repay the covered bonds, or a performance test has been breached. In a pass-through redemption, the issuer applies collections from the assets on each payment date to repay the principal on the notes, but the trustee does not need to liquidate the assets, because the maturity of the notes can be extended. The extension date typically depends on the remaining term of the assets, which could enable the issuer to hold the assets to maturity while retaining the option of liquidating assets in advance if market conditions are favorable. An amortization test will typically limit the volume of assets that the issuer can sell to repay any bond series, therefore mitigating the risk that investors in the longer-dated notes rely on insufficient assets to repay them.

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The EU Covered Bond Directive included conditions for extendable maturity structures, which further increased the share of covered bonds with soft bullet maturities. For example, German Pfandbriefe switched from hard to soft bullet structures by force of law in 2021. On the other hand, CPT issuance declined after peaking in 2019. This was mainly due to less favorable treatment from the European Central Bank (ECB), as CPT bonds lost their eligibility under the third covered bond purchase program (CBPP3) and attracted higher valuation haircuts when used as collateral in repo transactions with the ECB (see the "Central Banks And Covered Bonds" section).

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How Investors Are Protected

Coverage tests

Several factors, such as deteriorating portfolio performance or liquidity shortfalls resulting from asset-liability mismatches can limit the cover pool's ability to timely repay covered bonds after the issuer's insolvency. To mitigate such risks, covered bond issuers may be subject to minimum mandatory overcollateralization levels, whereby the asset balance generally needs to exceed the covered bond balance by a determined level. The amended article 129 of the Capital Requirements Regulation for example stipulates a 5% minimum overcollateralization level to qualify for preferential risk weight treatment (with member states allowed to opt for a lower minimum level, floored at 2%, if certain conditions apply).

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The breach of the minimum mandatory overcollateralization level has different consequences depending on the legal framework. These may include the revocation of the issuer's license to issue covered bonds, the suspension of the program, or the redirection of cash flows.

The issuer can decide to commit to higher levels of overcollateralization voluntarily. In several covered bond programs, issuers typically commit to a minimum level via contractual asset coverage tests (ACTs). These tests are designed to not only ensure a minimum ratio of cover pool assets for covered bonds, but also serve to enhance the credit quality of the assets in the portfolio, by excluding impaired assets from the eligible assets' balance and therefore incentivizing issuers to remove them from the cover pool. Compliance with the ACT is assessed periodically, typically monthly, and the uncured breach of the test normally triggers an issuer's insolvency.

Following the issuer's insolvency, the amortization test monitors the covered bond program's credit enhancement. The mechanics and calculation of this test are similar to the ACT, and it ensures that all outstanding covered bonds equally benefit from a minimum overcollateralization level.

Covered bond programs may include other tests in their structure, such as the net present value (NPV) test or the interest coverage test. The NPV test typically ensures that the NPV of the covered bonds is less than or equal to the cover pool's NPV, while the interest coverage test ensures the expected interest inflows from the portfolio will exceed the interest payments on the bonds for a predetermined time.

An unblemished credit history

While several covered bond issuers have defaulted over the product's long history, no covered bonds have ever defaulted. Strict asset eligibility criteria and ample overcollateralization have helped, but historically, regulators have preferred to assist the issuer servicing covered bond liabilities without reverting to a sale of assets in the cover pool--even after writing down or stopping payments to senior unsecured obligations.

Who Is Investing In Covered Bonds

While private banks and fund managers have historically been the main investors in covered bonds, central banks have played an increasingly important role, especially following the ECB's decision to include them in its asset purchase program in 2014.

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Since financial institutions are the main investors in covered bonds, the legal and regulatory framework that supervises the financial sector's activity is uniquely important for this market (see "The Regulatory Landscape" section.)

Central Banks And Covered Bonds

Central banks can have a significant impact on the covered bond market, mainly as buyers, but also by setting standards for collateral eligibility and by providing banks funding on favorable terms.

The ECB started purchasing covered bonds under its third covered bond purchase program (CBPP3) in October 2014, as part of a package of non-standard monetary policy measures that also included targeted longer-term refinancing operations (TLTRO).

At the peak, CBPP3 holdings reached just above €300 billion--more than one-third of the eligible outstanding covered bond universe--although the program is now phasing out. While CBPP3 may have supported issuance by reducing spreads, it also crowded out private sector investors more sensitive to pricing considerations.

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Issuers can also use retained covered bonds as collateral in standard repo transactions with central banks or under their longer-term funding facilities, such as the ECB's TLTRO III. Many central banks provide liquidity to the banking sector with repo transactions which require qualified counterparties to provide eligible collateral. The eligibility of covered bonds as collateral for central banks is also a requirement for many investors. While such eligibility has supported retained covered bonds issuance, it has depressed investor-placed covered bond issuance, by reducing banks' capital market funding needs. More than €700 billion of covered bonds issuance was registered as collateral when TLTRO III borrowings peaked.

The Covered Bond Market

The great financial crisis and the European sovereign debt crisis proved that covered bonds can be a resilient funding source even in times of wider market turmoil. Even in the countries most affected by the crisis, such as Italy and Spain, banks were able to access the covered bond market, despite other sources of wholesale funding evaporating. Issuers and regulators outside the traditional European markets recognized banks' ability to issue covered bonds and expedited the approval or the amendment of legislation governing their issuance.

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A surge in bank deposits and the availability of cheap central bank funding dampened investor-placed issuance in 2020-2021. But issuance bounced back to record levels post COVID-19, as deposit growth slowed and central banks reduced liquidity support. Despite global bank wobbles, surging inflation, and a softening economic outlook, investor-placed benchmark issuance exceeded €250 billion in 2023.

Covered bonds play a systemically important role in Europe

While retail deposits still fund most mortgage lending in Europe, covered bonds play an increasingly systemic role.

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Cover Pool Assets

Cover pool assets generally comprise either mortgage loans or public sector loans, and in more limited instances, shipping or small and midsize enterprise loans. Both residential and commercial loans can be included in cover pools. Public sector lending typically includes loans to--or guaranteed by--national, regional, and local authorities. Cover pools may also comprise a limited percentage of substitute assets, such as bank deposits or highly rated securities for overcollateralization or liquidity purposes.

By the turn of the century, covered bonds were mainly backed by public sector loans, but since then, mortgage loans have gained more market share (see chart 14). This was due to the reduced supply of assets eligible for German public sector covered bond programs following the withdrawal of public sector guarantees from state-owned banks (Landesbanks), and that debt issued by saving banks is no longer eligible.

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While the range of eligible cover pool assets for legislation-enabled covered bond programs is defined in the country-specific covered bond framework, structured covered bond programs normally define a set of eligibility criteria contractually. These eligibility criteria ensure minimum standards of portfolio credit quality, including maximum loan-to-value (LTV) ratios and property location restrictions.

The Regulatory Landscape

Covered bonds enjoy favorable regulatory treatment compared with many other asset classes because of their systemic importance and the relatively low risk profile of the product.

Since July 2022, EU regulatory treatment is based on a legislative package which consists of a directive that introduces a common definition of covered bonds, and a regulation that amends the EU's Capital Requirements Regulation. New covered bonds must meet its mandatory requirements to be eligible for favorable treatment. European covered bonds receive preferential regulatory treatment that extends beyond risk weightings in the bank capital framework to include favorable treatment under the liquidity coverage ratio and the net stable funding ratio standards; the definition of exposure and investment limits; the eligibility rules as collateral in central bank liquidity schemes; and the exemption from bail-in.

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Covered Bond Directive

European Union (EU) institutions and regulators finalized Directive (EU) 2019/2162 (the "Covered Bond Directive" or CBD) in November 2019. It became effective on July 8, 2022, after member states transposed it into their national laws. The CBD set out a principle-based harmonization framework for European covered bonds.

The directive:

• provides a common definition of covered bonds;
• defines the structural features of the instrument (dual recourse, quality of the assets backing the covered bond, liquidity, and transparency requirements, among others);
• defines the tasks and responsibilities for the supervision of covered bonds; and
• sets out the rules allowing the use of the European Covered Bond and European Covered Bond (Premium) labels.

Capital Requirements Regulation

Regulation (EU) No 575/2013 (the "Capital Requirements Regulation" or CRR) became effective on Jan. 1, 2014 and assigns low risk weights to covered bonds meeting certain bank capital requirement criteria. The risk weightings are a very important factor in banks' investment decisions. Article 129 of the CRR, which dictates the specific criteria for covered bonds to qualify for low risk weights, was amended in 2022 by Regulation (EU) 2019/2160, as part of the covered bond harmonization legislative package. The amended article 129 of the CRR includes additional requirements that covered bonds must fulfill to continue benefiting from preferential capital treatment. For example, it requires a 5% minimum overcollateralization level to qualify for preferential risk weight treatment (with member states allowed to opt for a lower minimum level, floored at 2%, if certain conditions apply.) It also defines the list of eligible cover pool assets and includes LTV ratio limits for real estate loans and ship mortgages, as well as minimum rating requirements for credit institution exposures.

Bank Recovery and Resolution Directive

Directive 2014/59/EU (the "Bank Recovery and Resolution Directive" or BRRD) was adopted in 2014 and establishes a framework for the recovery and resolution of credit institutions and investment firms. The BRRD defines the triggers for and the tools available under a failing bank's resolution: Sale, bridge institutions, asset separation, and bail-in. The BRRD significantly narrows governments' ability to support struggling banks. Under a bail-in, the resolution authority can write down liabilities or convert them into equity to absorb losses and apply recapitalization measures. Covered bonds have been excluded from the list of bail-in-able liabilities.

Liquidity Coverage Ratio Delegated Act

The Regulation (EU) 2015/61 (the "Liquidity Coverage Ratio Delegated Act" or "LCR") came into force on Oct. 1, 2015 and requires banks to hold a certain amount of liquid assets to cover their net cash outflows over 30 days. It introduces a favorable treatment for covered bonds, which are defined as liquid assets of level 1 and 2 in the LCR calculation. Considering the European Banking Authority estimates 10% or more of an average EU bank's total assets comprise a liquidity buffer, such favorable treatment has boosted the demand for eligible bonds.

Solvency II

Directive 2009/138/EC (the "Solvency II Directive"), adopted in November 2009, introduced risk-based capital charges for insurers. Article 180 of Regulation (EU) 2015/35 outlines the preferential capital treatment for covered bonds held by (re)insurance undertakings.

Third country equivalence

Preferential treatment in bank capital frameworks remains largely a European phenomenon; elsewhere, the treatment of covered bonds is mostly aligned with the Basel Committee's stipulations, meaning that covered bonds are barely treated better than senior unsecured instruments. Importantly, covered bonds issued by credit institutions outside the European Economic Area (EEA) and purchased by European investors receive less favorable regulatory treatment than covered bonds issued by EEA-based credit institutions.

However, European authorities could, in future, decide to grant equivalent treatment to covered bonds issued by non-EEA credit institutions. Alignment of third country covered bond frameworks with the directive will be a key factor. Article 31 of the directive stipulates that the European Commission (EC) will submit a report on third country equivalence to the European Parliament and Council by July 2024. The report may be accompanied by a legislative proposal on the possible introduction of an equivalence regime.

Our Analytical Approach

Our credit ratings are designed primarily to provide a forward-looking opinion about the relative rankings of overall creditworthiness among issuers and obligations.

In an indirect way, our consideration of absolute default likelihood can be viewed as associating stress tests or scenarios of varying severity with the different rating categories. For example, we would expect issuers or securities with higher ratings to withstand more severe macroeconomic scenarios without defaulting. Those rated lower would generally have less capacity to withstand these more severe scenarios. In other words, the higher the rating category, the more severe the stress level associated with that category.

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Our covered bond ratings process follows the methodology and assumptions outlined in our "Covered Bonds Criteria," published on Dec. 9, 2014, and "Covered Bond Ratings Framework: Methodology And Assumptions," published on June 30, 2015. For a full description of our methodology, please refer to these criteria.

We organize our analytical process for rating covered bonds into four key stages:

• Perform an initial analysis of issuer-specific factors--legal and regulatory risks and operational and administrative risks--which mainly assesses whether a rating on the covered bond may be higher than the rating on the issuer;
• Assess the starting point for the rating analysis based on the relevant resolution regimes;
• Determine the maximum achievable covered bond rating based on an analysis of jurisdictional and cover pool-specific factors; and
• Combine the above results and incorporate any additional factors, such as counterparty risk and country risk, to determine the final covered bond rating.

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Step 1: Initial analysis

The primary aim of the initial analysis of the covered bond ratings framework is to determine whether the covered bond rating may exceed the rating on the issuer. Due to the dual-recourse nature of covered bonds, the covered bond rating is typically no lower than the relevant rating on the covered bond issuer.

Legal and regulatory risks

The assessment of legal and regulatory risks focuses primarily on the degree to which a covered bond program isolates the cover pool assets from the bankruptcy or insolvency risk of the covered bond issuer. If the asset isolation analysis concludes that the covered bonds are not likely to be affected by the bankruptcy or insolvency of the issuer, then we may assign a rating to the covered bonds that is higher than the rating on the issuer.

Operational and administrative risks

The analysis of operational and administrative risks focuses on key transaction parties to assess whether we consider they would be capable of managing a covered bond program for as long as any bonds issued remain outstanding. The key transaction party in a covered bond program is typically the issuer, which originates, underwrites, and services the cover pool assets. To potentially assign a rating on the covered bonds that is higher than that on the issuer, our analysis considers the possibility that the issuer may be unable to perform its role and contemplates the likelihood of a replacement.

Step 2: Determination of the reference rating level

For ratings on covered bonds that may exceed those on the issuer, as we determine according to step 1, we then proceed to step 2, to determine the starting point for our analysis or reference rating level (RRL). This reflects the likelihood that the issuer can service the covered bonds from its own funds. In general, the RRL is at least equal to the issuer credit rating (ICR).

Furthermore, certain resolution schemes, although their purpose is to limit government support to failing banks, also support a more protective status for covered bonds than for most other bank liabilities. This is the case for the EU's BRRD, for example. In this case, an issuer may continue to service protected liabilities, such as covered bonds, even though it may default on other types of liabilities. We therefore may assign an RRL up to two notches higher than the ICR, reflecting our view of the resolution scheme's effect on the issuer's ability to pay the covered bonds.

Step 3: Determination of the maximum achievable covered bond rating

If the issuer defaults and is not restored as a going concern following a bank resolution, the covered bond program would turn to sources other than its issuing bank to meet payments and to mitigate its refinancing risk. This third step of the covered bond ratings framework determines the maximum achievable covered bond rating, i.e., the rating level that is consistent with the available credit support to achieve repayment on the covered bonds.

Jurisdictional support

In our jurisdictional support analysis, we assess the likelihood that a covered bond facing stress would receive support from a government-sponsored initiative instead of from the liquidation of collateral assets in the open market.

Our assessment of jurisdictional support is based on: 1) the strength of the legal framework; 2) the systemic importance of the covered bonds in their jurisdiction; and 3) the sovereign's credit capacity to support the covered bonds. Based on the above factors, we establish a four-point classification of jurisdictional support: very strong, strong, moderate, and weak. Depending on our assessment, the criteria provide for potential rating uplift of up to three notches above our RRL on the covered bond.

If we give credit to jurisdictional support in our analysis, our jurisdiction-supported rating level (JRL) is capped at the foreign currency rating on the country in which the covered bond issuer is based.

Collateral support

We then consider to what extent overcollateralization enhances the creditworthiness of a covered bond issue by allowing the cover pool to raise funds from a broader range of investors and so address its refinancing needs. This overcollateralization may cover the credit risk only, the expected losses incurred by the cover pool in a stressed scenario, or also the refinancing costs, that is, the additional collateral required to raise funds against its assets to repay maturing covered bonds. We refer to this as "collateral-based uplift".

The "maximum collateral-based uplift" for a given covered bond program depends on our view about the presence of active secondary markets for the cover pool assets (to enable the covered bond to raise funds against its assets):

• We may allow up to four notches of collateral-based uplift above the JRL for overcollateralization covering credit risk and refinancing costs where we believe active secondary markets exist to enable the issuer to raise funds against its assets; or
• We may allow up to two notches of rating uplift above the covered bond's JRL for overcollateralization to cover credit risk only, in jurisdictions that we believe do not have a sufficiently active secondary market to enable the issuer to raise funds against its assets.

Our analysis of the covered bonds' payment structure considers whether cash flows from the cover pool assets would be sufficient, at the given rating, to make timely payment of interest and ultimate principal to the covered bond on its legal final maturity date.

We also consider whether the overcollateralization is committed or voluntary, and whether liquidity is available for managing market-based refinancing strategies. The uncommitted overcollateralization or lack of committed liquidity may reduce the collateral-based uplift.

Step 4: Additional factors

The aim of the fourth and final stage of the covered bond ratings framework is to determine whether considerations not directly related to the covered bond issuer and covered bond program would limit the maximum achievable covered bond rating (based on the previous two stages). This stage assigns the final covered bond rating after considering the impact of these additional factors.

Counterparty risk

Counterparty exposure is an important factor when assessing a covered bond program's credit risk because a counterparty's failure to perform on its obligations may lead to a payment default on the bonds. The analysis focuses on obligations arising from third parties that either hold assets or make financial payments that may affect the creditworthiness of covered bonds. Typical examples of entities posing counterparty risk in covered bonds are the parent or related entities, bank account providers, and derivative counterparties.

Country risk

The sovereign default risk analysis considers sovereign and country risks for the jurisdiction of the assets and the issuer. Our structured finance sovereign risk criteria determine a maximum rating differential above the long-term sovereign rating as a function of the underlying assets' sensitivity to sovereign default risk and the sensitivity of the covered bond structure to refinancing risk. We categorize the underlying assets' sensitivity to sovereign default risk as high, medium, or low and then combine the assessment with the covered bonds' exposure to refinancing risk to assess the maximum differential above the sovereign rating.

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Structural mechanisms to cover refinancing needs over a 12-month period can include liquidity reserves, in which upcoming maturity payments are pre-funded, or extendable maturities.

Where a program has outstanding foreign-currency-denominated covered bonds, the ratings on the covered bonds may be constrained by our transfer and convertibility (T&C) risk assessment. Our T&C assessment reflects our view of the likelihood of a sovereign restricting access to foreign exchange needed to satisfy debt service obligations. Unless structural mitigants for T&C risk apply, such as a political risk insurance or third-party guarantees, we would cap the ratings on the covered bonds at the country's T&C assessment.

Related Criteria

• Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019
• Sovereign Risk In Rating Structured Finance Securities: Methodology And Assumptions, Jan. 30, 2019
• Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Global Covered Bond Insights, published quarterly
• Glossary Of Covered Bond Terms, April 27, 2018