Prior to the onset of the credit crisis in 2008, covered bonds were seen by investors as a generic triple-A quality asset class. Valuations were homogenous across all jurisdictions and reflected assumptions of near zero default probability and negligible loss severities due to their long history since their advent in 1769.
Covered bonds are securities issued by a financial institution and backed by a group of loans residing on the balance sheet known as the "cover pool". The assets in the pools can consist of high-quality private mortgage loans or public sector loans or a mix of the two. Central to the success of the asset class, and correspondingly valuations, is the dual recourse characteristic in which covered bond investors are given a priority claim to a segregated on-balance sheet pool of assets parallel with a senior claim to the issuer which ranks pari passu with senior unsecured creditors.
Traditional covered bond investors showed high confidence in the asset class by requiring a low risk premium to "risk-free" assets such as U.S. Treasuries, which are generally considered to be risk-free because they are backed by the U.S. government. All investments contain risk and may lose value. In hindsight, this view of covered bonds could be seen as non-commensurate with the actual credit, refinancing and liquidity risks inherent in covered bonds. These risks have revealed themselves in recent episodes of market stress as the credit strength of issuing entities and the quality of cover pool collateral were questioned.
During the financial crisis, the credit strength of the financial credit sector as a whole came under scrutiny and, as is commonly known, central to the problem was nonperformance of mortgage assets resulting from loose origination standards, complex securitization techniques and deteriorating underlying macroeconomic variables such as declining house prices and rising unemployment. More recently, credit risk of public sector loans from distressed European economies is experiencing a similar reassessment.
The natural consequence of weakening collateral performance and issuer credit fundamentals has been the scrutiny of structural features of individual covered bond programs. Although simplistic in comparison to asset-backed securities (ABS) or mortgage-backed securities (MBS), as covered bond structures are on balance sheets and do not utilize securitization techniques such as "tranching" or subordination, covered pools are dynamic open structures -- the issuer may add and remove cover pool assets (i.e. mortgage loans) and/or issue or retire liabilities (covered bonds). Thus the cover pool is ?live? and continuously mutating.
Credit enhancements features, asset liability amortization mismatches and collateral performance thus change with time. Consequently, a concern associated with covered bonds is less-than-perfect transparency.
However, the market is expanding rapidly, both in terms of secondary market liquidity and primary market supply. This growth has been fueled by :
1. Strong demand from a large investor base of natural buyers. 2. Regulatory developments such as Basel III and Solvency II. 3. Explicit support from central banks like the European Central Bank (ECB) via its Covered Bond Purchase Program (CBPP). This combination has created a vibrant environment and global momentum for covered bonds.
