Covered bonds are debt instruments secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default. While the nature of this preferential claim, as well as other safety features (asset eligibility and coverage, bankruptcy-remoteness and regulation) depends on the specific framework under which a covered bond is issued, it is the safety aspect that is common to all covered bonds.
Covered bonds are increasingly used in the marketplace as a funding instrument, in addition to savings deposits, senior issuances, mortgage-backed- securities, etc. The issuance of covered bonds enables credit institutions to obtain lower cost of funding in order to grant mortgage loans for housing and non-residential property as well as, in certain countries, to finance public debt. The portfolio investor has the advantage of investing in safe bonds with a relatively high return. Thus, covered bonds play an important role in the financial system.
The internationalisation of formerly domestic covered bond markets began more than 15 years ago with the introduction of a new benchmark product attracting international institutional investors and providing the necessary market liquidity.
As a consequence, many European countries have introduced new covered bond legislation or have updated existing rules to be a part of this development and to also respond to the considerable growth of mortgage lending activities in the European Union. With over EUR 2.57 trillion outstanding at the end of 2018, covered bonds play an important role in European capital markets, contributing to the efficient allocation of capital and, ultimately, economic development and recovery.
The ECBC sets out below what it considers to be the essential features of covered bonds, together
with explanatory notes.
It is intended that they be read independently from any other definition or interpretation of covered
bonds, such as those set out in the undertakings for collective investment in transferable securities
(UCITS) and Article 129(1) of the Capital Requirements Regulation (CRR).
These common essential features should be understood as the ECBC’s minimum standards for covered
Covered bonds are characterised by the following common essential features that are achieved under
special-law based frameworks or general-law based frameworks:
The basic characteristics of covered bonds have been enshrined in the Directive Directive on Undertakings for Collective Investments in Transferable Securities (UCITS). Article 52(4) of this Directive defines the minimum requirements that provide the basis for privileged treatment of covered bonds in different areas of European financial market regulation. In brief, Article 52(4) requires:
Covered bonds that comply with those requirements are considered as particular safe investments, which justify the easing of prudential investment limits. Therefore, investment funds (UCITS) can invest up to 25% (instead of max. 5%) of their assets in covered bonds of a single issuer that meet the criteria of Article 52(4). Similar, the EU Directives on Life and Non-Life Insurance (Directives 92/96/EEC and 92/49/EEC) allow insurance companies to invest up to 40% (instead of max. 5%) in UCITS compliant covered bonds of the same issuer. All 27 EU Member States have sent UCITS notifications to the Commission, with 24 Member States notifying that they have authorised issues fulfilling the UCITS criteria of Article 52(4).
“1. A UCITS shall invest no more than:
(a) 5 % of its assets in transferable securities or money market instruments issued by the same body; or
(b) 20 % of its assets in deposits made with the same body.
4. Member States may raise the 5 % limit laid down in the first subparagraph of paragraph 1 to a maximum of 25 % where bonds are issued by a credit institution which has its registered office in a Member State and is subject by law to special public supervision designed to protect bond-holders. In particular, sums deriving from the issue of those bonds shall be invested in accordance with the law in assets which, during the whole period of validity of the bonds, are capable of covering claims attaching to the bonds and which, in the event of failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued interest.”
The delegated act of Solvency II secures a favourable treatment under Solvency II for covered bonds. A low-spread risk factors is in fact assigned to covered bond—i.e. preferential treatment under the spread risk module and concentration risk module.
1. Exposures in the form of bonds referred to Article 52(4) of Directive 2009/65/EC (covered bonds) which have been assigned to credit quality step 0 or 1 shall be assigned a risk factor stressi according to the following table.
|Credit Quality Step
|Up to 5||0.7% dur||min (3.5% + 0.5% · (duri – 5) ; 1)|
|More than 5 years||0.9% dur||min (4.5% + 0.5% · (duri – 5) ; 1)|
The BRRD has important direct and indirect implications for covered bonds, particularly as
it exempts UCITS-compliant covered bonds from the scope of the bail-in tool, under specific
conditions (Article 44(2)).
ARTICLE 44(2) – SCOPE OF BAIL-IN TOOL
2. Resolution authorities shall not exercise the write down or conversion powers in relation to the following liabilities whether they are governed by the law of a Member State or of a third country:
(b) secured liabilities including covered bonds and liabilities in the form of financial Instruments used for hedging purposes which form an integral part of the cover pool and which according to national law are secured in a way similar to covered bonds;
Member States shall ensure that all secured assets relating to a covered bond cover pool remain unaffected, segregated and with enough funding. Neither that requirement nor point (b) of the first subparagraph shall prevent resolution authorities, where appropriate, from exercising those powers in relation to any part of a secured liability or a liability for which collateral has been pledged that exceeds the value of the assets, pledge, lien or collateral against which it is secured.”
Central to the covered bond regulations at EU Level is the Liquidity Coverage Requirement
(LCR) treatment, which was specified by the European Commission through a Delegated Act under the Capital Requirements Regulation. The LCR Delegated Act—which entered into force on 1 October 2015 and will be fully implemented at the beginning of 2018 and which represents EU-wide implementation of the Basel’s LCR rules—introduces a favourable treatment for covered bonds. The treatment is specific to EU and aims to reflect credit quality, liquidity performance and the role of covered bonds in the funding markets of the EU. It allows covered bonds to be included in Level 1, 2A and 2B liquid assets for the purposes of calculating their LCR under specific criteria. Furthermore, covered bonds can be included up to 70% in the liquidity buffer (leaving 30% for the highest liquid Level 1 assets such as Level 1 government bonds).
1. Level 1 assets shall only include assets falling under one or more of the following categories and meeting in each case the eligibility criteria laid down herein:
(f) exposures in the form of extremely high quality covered bonds, which shall comply with all of the following requirements:
(i) they are bonds as referred to in Article 52(4) of Directive 2009/65/EC or meet the requirements to be eligible for the treatment set out in Article 129(4) or (5) of Regulation (EU) No 575/2013;
(ii) the exposures to institutions in the cover pool meet the conditions laid down in Article 129(1)(c) and in Article 129(1) last subparagraph of Regulation (EU) No 575/2013;
(iii) the credit institution investing in the covered bonds and the issuer meet the transparency requirement referred to in Article 129(7) of Regulation (EU) No 575/2013;
(iv) their issue size is at least EUR 500 million (or the equivalent amount in domestic currency);
(v) the covered bonds are assigned a credit assessment by a nominated ECAI which is at least credit quality step 1 in accordance with Article 129(4) of Regulation (EU) No 575/2013, the equivalent credit quality step in the event of a short term credit assessment or, in the absence of a credit assessment, they are assigned a 10% risk weight in accordance with Article 129(5) of that Regulation;
(vi) the cover pool meets at all times an asset coverage requirement of at least 2% in excess of the amount required to meet the claims attaching to the covered bonds;
1. Level 2A assets shall only include assets falling under one or more of the following categories and meeting in each case the eligibility criteria laid down herein:
(c) exposures in the form of high quality covered bonds, which shall comply with all of the following requirements:
(d) exposures in the form of covered bonds issued by credit institutions in third countries, which shall comply with all of the following requirements:
1. Level 2B assets shall only include assets falling under one or more of
the following categories and meeting in each case the eligibility criteria
laid down herein:
(e) exposures in the form of high quality covered bonds which shall comply with all of the following requirements:
The RTS on risk mitigation techniques for OTC derivative contracts not cleared by a CCP, developed under the European Market Infrastructure Regulation, provide for a specific treatment of cover pool derivatives (derivatives entered into by covered bond issuers for the hedging of the cover pool’s market risks and included within the scope of the protective measures established by the respective covered bond regime). The RTS set out a specific set of conditions under which such cover pool derivatives, which are concluded with regard to covered bonds compliant with Article 129 of the CRR, are exempted from margin requirements in the context of bilateral clearing (i.e. clearing not executed through a CCP).
“1. By way of derogation from Article 2(2) and where the conditions set out in paragraph 2 of this Article are met, counterparties may, in their risk management procedures, provide the following in relation to OTC derivative contracts concluded in connection with covered bonds:
(a) variation margin is not posted by the covered bond issuer or cover pool but is collected from its counterparty in cash and returned to its counterparty when due;
(b) initial margin is not posted or collected.
2. Paragraph 1 applies where all of the following conditions are met:
(a) the OTC derivative contract is not terminated in case of resolution or insolvency of the covered bond issuer or cover pool;
(b) the counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds ranks at least pari passu with the covered bond holders except where the counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds is the defaulting or the affected party, or waives
the pari passu rank;
(c) the OTC derivative contract is registered or recorded in the cover pool of the covered bond in accordance with national covered bond legislation;
(d) the OTC derivative contract is used only to hedge the interest rate or currency mismatches of the cover pool in relation to the covered bond;
(e) the netting set does not include OTC derivative contracts unrelated to the cover pool of the covered bond;
(f) the covered bond to which the OTC derivative contract is associated meets the requirements of paragraphs (1), (2) and
(3) of Article 129 of Regulation (EU) No 575/2013;
(g) the cover pool of the covered bond to which the OTC derivative contract is associated is subject to a regulatory collateralisation requirement of at least 102 %.”
Another cornerstone is the Capital Requirements Regulation (CRR). It is based on a proposal
from the Basel Committee on Banking Supervision to revise the supervisory regulations
governing the capital adequacy of internationally active banks. The package entered into
force on 17 July 2013 and replaced the Directives 2010/76/EU, 2006/48/EC and 2006/49/EC.
Covered bonds are defined in Article 129 of the CRR.
1. To be eligible for the preferential treatment set out in paragraphs 4 and 5, bonds as referred to in Article 52(4) of Directive 2009/65/EC (covered bonds) shall meet the requirements set out in paragraph 7 and shall be collateralised by any of the following eligible assets:
(a) exposures to or guaranteed by central governments, ESCB central banks, public sector entities, regional governments or local authorities in the Union;
(b) exposures to or guaranteed by third country central governments, third-country central banks, multilateral development banks, international organisations that qualify for the credit quality step 1 as set out in this Chapter, and exposures to or guaranteed by third-country public sector entities, third-country regional governments or third-country local authorities that are risk weighted as exposures to institutions or central governments and central banks in accordance with Article 115(1) or (2), or Article 116(1), (2) or (4) respectively and that qualify for the credit quality step 1 as set out in this Chapter, and exposures within the meaning of this point that qualify as a minimum for the credit quality step 2 as set out in this Chapter, provided that they do not exceed 20 % of the nominal amount of outstanding covered bonds of the issuing institutions;
(c) exposures to institutions that qualify for the credit quality step 1 as set out in this Chapter. The total exposure of this kind shall not exceed 15 % of the nominal amount of outstanding covered bonds of the issuing institution. Exposures to institutions in the Union with a maturity not exceeding 100 days shall not be comprised by the step 1 requirement but those institutions shall as a minimum qualify for credit quality step 2 as set out in this Chapter;
(d) loans secured by:
(e) residential loans fully guaranteed by an eligible protection provider referred to in Article 201 qualifying for the credit quality step 2 or above as set out in this Chapter, where the portion of each of the loans that is used to meet the requirement set out in this paragraph for collateralisation of the covered bond does not represent more than 80 % of the value of the corresponding residential property located in France, and where a loan-to-income ratio respects at most 33 % when the loan has been granted. There shall be no mortgage liens on the residential property when the loan is granted, and for the loans granted from 1 January 2014 the borrower shall be contractually committed not to grant such liens without the consent of the credit institution that granted the loan. The loan-to-income ratio represents the share of the gross income of the borrower that covers the reimbursement of the loan, including the interests. The protection provider shall be either a financial institution authorised and supervised by the competent authorities and subject to prudential requirements comparable to those applied to institutions in terms of robustness or an institution or an insurance undertaking. It shall establish a mutual guarantee fund or equivalent protection for insurance undertakings to absorb credit risk losses, whose calibration shall be periodically reviewed by the competent authorities. Both the credit institution and the protection provider shall carry out a creditworthiness assessment of the borrower;
(f) loans secured by:
Loans secured by commercial immovable property are eligible where the Loan to Value ratio of 60 % is exceeded up to a maximum level of 70 % if the value of the total assets pledged as collateral for the covered bonds exceed the nominal amount outstanding on the covered bond by at least 10 %, and the bondholders’ claim meets the legal certainty requirements set out in Chapter 4. The bondholders’ claim shall take priority over all other claims on the collateral;
(g) loans secured by maritime liens on ships up to the difference between 60 % of the value of the pledged ship and the value of any prior maritime liens.
For the purposes of points (c), (d)(ii) and (f)(ii) of the first subparagraph, exposures caused by transmission and management of payments of the obligors of, or liquidation proceeds in respect of, loans secured by pledged properties of the senior units or debt securities shall not be comprised in calculating the limits referred to in those points.
The competent authorities may, after consulting EBA, partly waive the application of point (c) of the first subparagraph and allow credit quality step 2 for up to 10 % of the total exposure of the nominal amount of outstanding covered bonds of the issuing institution, provided that significant potential concentration problems in the Member States concerned can be documented due to the application of the credit quality step 1 requirement referred to in that point.
2. The situations referred to in points (a) to (f) of paragraph 1 shall also include collateral that is exclusively restricted by legislation to the protection of the bond-holders against losses.
3. Institutions shall for immovable property collateralising covered bonds meet the requirements set out in Article 208 and the valuation rules set out in Article 229(1).
4. Covered bonds for which a credit assessment by a nominated ECAI is available shall be assigned a risk weight according to Table 6a which corresponds to the credit assessment of the ECAI in accordance with Article 136.
|Credit Quality Step||1||2||3||4||5||6|
5. Covered bonds for which a credit assessment by a nominated ECAI is not available shall be assigned a risk weight on the basis of the risk weight assigned to senior unsecured exposures to the institution which issues them. The following correspondence between risk weights shall apply:
(a) if the exposures to the institution are assigned a risk weight of 20 %, the covered bond shall be assigned a risk weight of 10 %;
(b) if the exposures to the institution are assigned a risk weight of 50 %, the covered bond shall be assigned a risk weight of 20 %;
(c) if the exposures to the institution are assigned a risk weight of 100 %, the covered bond shall be assigned a risk weight of 50 %;
(d) if the exposures to the institution are assigned a risk weight of 150 %, the covered bond shall be assigned a risk weight of 100 %.
6. Covered bonds issued before 31 December 2007 are not subject to the requirements of paragraphs 1 and 3. They are eligible for the preferential treatment under paragraphs 4 and 5 until their maturity.
7. Exposures in the form of covered bonds are eligible for preferential treatment, provided that the institution investing in the covered bonds can demonstrate to the competent authorities that:
(a) it receives portfolio information at least on:
(b) the issuer makes the information referred to in point (a) available to the institution at least semi-annually.”