Covered Bonds: Mundane or Misunderstood?

Covered Bonds do not often make headlines, except in a small number of specialist publications. With the upcoming changes to ESMA’s transparency regime, however, this could be set to change.

Unlike the FCA, ESMA has chosen to split Covered Bonds into their own group and set deferral rules specifically aligned with the way they trade in the secondary markets.

What Are Covered Bonds?

A Covered Bond is a debt instrument secured by a pool of assets that remain on the issuing bank’s balance sheet¹. Unlike other asset-backed securities, there is no Special Purpose Vehicle (SPV) set up to hold the assets. Due to this structure, investors are ‘covered’ in the event of default, as the pool of assets (which is likely to be comprised of mortgages and loans) should make them whole in the event of an issuer default.

This structure can be highly attractive to risk-averse investors, as it provides a dual-recourse approach in the event of default², with both the issuer and pool of assets being potential avenues for the investor to recover their capital.

Given their unique features, Covered Bonds often attract high credit ratings (an AAA rating is not uncommon³). Partly for this reason, they often get thrown in with SSA’s (sub-sovereign, supranational and agency bonds). Whilst it is easy to understand why, they are significantly different.

Table 1 shows that Covered Bonds and SSA’s share many characteristics, with the main differences relating to the behaviour in the event of a default and the type of issuing institutions. Also interesting is the shared characteristic around the market convention to trade over “mid-swaps” (otherwise known as the i-spread).

To expand on this concept, high-quality assets (particularly those denominated in EUR) price over swaps rather than over a government bond. This is less common for USD-denominated assets, which typically remain benchmarked against US Treasuries. With the improving liquidity of SONIA Overnight Index Swaps, GBP high-quality assets are increasingly priced over mid-swaps rather than Gilts.

Whilst the simple answer for this trend is “market convention”, another explanation is that investors in high-quality assets are looking to pick up a spread over a reference rate (e.g. SONIA or EURIBOR). As such, they may swap the bond cash flows from fixed to floating, locking in a spread over the reference rate for the lifespan of the bond.

Deferral Treatment

ESMA and the FCA take differing approaches to the treatment of Covered Bonds and MiFID trade reporting. ESMA provides a separate category, specifically for Covered Bonds, whereas the FCA does not (instead they are reported under the Corporate Bond deferral rules).

Table 2 below is a breakdown of the ESMA Covered Bond price dissemination rules. The key takeaway is that a trade for EUR 20 MM (equivalent) would be deferred for 15 minutes under ESMA rules, but two weeks under FCA rules.

Geographic Breakdown

It is widely acknowledged that the German Covered Bond market is one of the most active in terms of primary issuance⁴. So much so, that the German term Pfandbrief is often used interchangeably with Covered Bonds, regardless of country.

What is perhaps less widely known is that, although Germany is (typically) a hotbed of issuance, it is not always the most active secondary market. Whilst this may be a surprise, it is (anecdotally) put down to the fact that many German investors take a buy-and-hold approach. In other markets, although this is still the case for many, there is (proportionally) more secondary turnover.

Chart 1 shows the average daily EUR-equivalent turnover for Covered Bonds across ESMA and FCA reporting venues.

It is apparent that Nordic-issued Covered Bonds have active secondary markets, with Denmark and Sweden leading the way. This is not overly surprising, given that Covered Bonds are associated with stable Northern European economies. However, the relatively low turnover observed in Germany is perhaps less intuitive than might be expected.

A further observation is how low (in absolute terms) the volumes are. This can, however, be explained by considering what is actually being shown. Firstly, we are taking the mean daily volume for the MiFID venues covered by Propellant Digital. It is likely that some activity takes place outside this scope (and as we take the mean here, it is reasonable to assume that this is pulled lower by low volume days). Furthermore, the breakdown is presented by issuer rather than by trading location. If we considered an alternative view, we might see the distribution shape change. (For example, the Netherlands may be likely to move up the ladder as many trading venues are based there).

¹ https://www.investopedia.com/terms/c/coveredbond.asp

²https://en.wikipedia.org/wiki/Covered_bond

³https://www.arlingclose.com/insights/back-to-basics-covered-bonds

⁴https://pfandbrief.market/en/german-pfandbriefe-key-driver-of-covered-bond-issuance