Covered Bonds

Covered bonds are a category of bonds backed by a pool of high-quality assets (like mortgages, gold loans, vehicle loans). These bonds provide investors with dual recourse protection—a claim against both the issuer and the cover pool assets. It is a secured bond issued by banks and NBFCs, offering higher yields, high security and fixed interest payments.

Dual recourse protection to the investor

The investor has both the right to claim on the issuer’s asset (primary recourse) and segregated ‘cover pool’ assets (secondary recourse), if the issuer defaults. Let’s understand in detail.

Primary recourse

Bondholders have a direct and general claim against the issuer, similar to secured corporate bonds.

Secondary recourse

If the issuer becomes insolvent, bondholders have access to a high-quality cover pool of assets before other creditors. Cover pool assets refer to those assets that are held in a bankruptcy remote Special Purpose Vehicle (SPV), distinct from the originator. The assets include unsecured personal loans, business loans, home loans, negotiable warehouse receipts, or loans against property.

Over-collateralization

Covered bond transactions are usually over-collateralized. This means that the value of receivables in the cover pool exceeds the bond issue size. This provides an additional safety buffer for investors.

Higher credit ratings

Covered bonds usually receive higher credit ratings, such as AAA, than the issuer's standalone rating due to the additional asset pool security. For example, a bank with a credit rating of AA can issue covered bonds rated AAA.

Both covered bonds and mortgage-backed securities or securitization are collateralized by loans but they differ in terms of dual recourse, on-off balance sheet, pricing, credit rating, safety, etc.

Both covered bonds and corporate bonds provide fixed interest payments, but they differ in terms of asset pool, credit rating, recourse, risk level, etc.