Issuance of covered bonds—bonds issued by financial institutions and backed by high-quality assets on the issuer’s balance sheet—is rising this year compared to other FI issuances of other debt products.
Primarily a Europe-centric product that has some traction among issuers in Australia and Canada, global covered bond issuance reached record levels in 2023. Activity levels remained robust in Q1 2024, exceeding €75 billion and putting the market on track to nearly matching last year’s all-time highs.
Covered bonds have been a comparative “safe haven” for investors amid the disruption that has beset credit markets over the past 18 months. The bonds are typically secured against resilient, high-quality assets (such as mortgages and public sector loans) that are held on the relevant financial institution’s balance sheet. This asset class therefore offers investors the protection of a dual recourse repayment structure in the event of non-performance of the issuer.
Investors not only have recourse against the issuer, but also the underlying pool of assets. These underlying assets, or cover pools, are ring-fenced; typically exceed the face value of the covered bonds issued; and are monitored by an independent third party to maintain credit quality and overcollateralization targets.
Yields from covered bonds are lower than those on offer from unsecured and sub-investment grade debt but are higher than the yields offered by government securities with comparable maturities. This makes them a good fit for more conservative investors who may not consider allocations to other forms of bank debt.
Covered bonds are also regulated, with country specific regulations setting out detailed and specific criteria for what kinds of assets are eligible to go into covered bond pools, providing an additional layer of comfort for investors.
Lowering cost of capital for banks
Issuing covered bonds also benefits financial institutions. Amid higher base borrowing rates, the lower issue margins on covered bond debt have allowed issuers to keep rising financing costs manageable for their treasuries.
Covered bonds are also designed in compliance with the regulations to specifically meet the requirements of a particular investment class, with these investors running specialized desks set up exclusively to assess investment opportunities in covered bonds.
The increase in demand for covered bonds has enabled financial institutions’ treasuries to broaden their investor bases, diversify funding sources and secure more capital from covered bond desks during this recent period of market disruption.
Moreover, covered bond issuance has proven to be especially attractive as a funding source as central banks have wound down pandemic-era support measures.
Looking ahead
The covered bond asset class is expected to remain of interest for investors and issuers in the coming months, with interest rate reductions not materializing as quickly as some analysts anticipated and investors remaining cautious.
The biggest challenge for the market will be the ability of issuers to replenish and grow the stock of assets for the cover pool that are of sufficient quality to meet the eligibility criteria of covered bond regulations.
Approvals of household mortgages, one of the main asset groups that underpin covered bonds, slowed in Europe throughout 2023 and in Q1 2024. Higher interest rates made it more difficult for some home buyers to secure affordable mortgage packages, reducing, in part, the available pool of mortgage assets against which banks could issue covered bonds.
However, there are some positive market signals. In the UK, for instance, mortgage approval rates have improved through H1 2024. But after the frenetic levels of covered bond issuance in 2023, it will take time for banks to organize recently issued mortgages into cover pools that underpin new covered bonds through the end of 2024.
The increase in demand for covered bonds has also had implications for investors. Though they still clearly have an appetite to deploy investment funds into covered bonds, investors have deployed so much capital into these products over the past 12 to 18 months that many may be at risk of bumping up against limits on the volume of covered bonds they can buy from any one issuer at a given time. There is, however, growing optimism that the momentum behind covered bond issuance in the core European market will generate more activity in the space from non-European banks.
The rigor and clarity of the covered bond regulatory framework in the EU has been a cornerstone of the product’s popularity and stability. Investors are looking out for other jurisdictions that can put regulatory frameworks in place that harmonize with the EU criteria and create eligible covered bond instruments.
If standardization and harmonization of covered bond regulation across jurisdictions deepens, the specialized groups of covered bonds investors will have a much wider pool of assets to invest in, helping to sustain robust issuance and grow the market.
