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Covered Bonds

What are Covered Bonds?

    • Covered Bonda are a hybrid between asset-backed securities/mortgage backed securities and normal secured corporate bonds

    • They are primarily used by mortgage lenders and act as a tool for refinancing

Who issues these Bonds?

  • Covered Bonds are issued by corporates.

Features of Covered Bonds

  • Dual recourse – The investor shall have two recourses – first, on the issuer, and second, on the cover pool.

  • Considered safer than normal bonds because of additional cushion

  • Due to the complexity and investment requirements, the investors are generally institutions and HNI

Types of Covered Bonds

  • (1) Legislative covered bonds- These bonds obtain legislative support which makes the instrument bankruptcy remote.

  • (2) Contractual covered bonds- These bonds obtain bankruptcy remoteness through contractual features.

How does Standard covered bond issuance reflect?

A standard covered bond issuance would reflect on:

  • On balance sheet – Both the cover pool and the liability towards the investor falls on the balance sheet of the issuer with respect to the covered bonds. The investor has recourse on the covered bond issuer. However, the rising cover pool remains circumscribed and is safeguarded even if the issuer has to go through bankruptcy.

  • Dual recourse – The investor has to face two recourses- first one on the issuer and the second one on the cover pool.

  • Dynamic or static pool – The cover pool may be dynamic or static, subject to the structure.

  • Prepayment risk – Since, the primary exposure falls on the issuer, any prepayment risk is absorbed by the issuer.

  • Rating arbitrage – Covered bonds ratings are normally higher than the issuer’s rating. Internationally, covered bonds enjoy the prestige of a maximum of 6-notch better rating as compared to the issuer’s rating.

Who are the main investors in Covered Bonds?

  • The covered bondholders have a preferential claim against a dedicated pool of collateral assets or the proceeds of these assets.

  • The investors can exercise full recourse to the issuer.

  • There is a supplementary dynamic collateral pool that supports the covered bonds, to protect the funds of the investors.

Who are the Investors in Covered Bonds?

The investors in the covered bond are classified into small private investors to large institutional ones. Mostly investors who are aiming to invest for long maturity periods and willing to take only low risk to invest in covered bonds. The investors in covered bonds include:

  • Central Banks

  • Bank Treasuries

  • Pension Funds

  • Insurance Companies

  • Asset Managers

Legislative Framework for Covered Bonds in India

At present, there is no specific law relating to the governance of the covered bond’s issuance in India. Hence, the interim solution for the covered bonds is a contractual arrangement covered under the general law of India. By that time the specific legislation relating to the covered bond is passed, the issuance of covered bonds can be regulated under the general law subject to the contractual agreement between the issuer and the investor. Hence, the Contract Act, 1872 provisions would be applied in this agreement’s case.

Best Practice in context to Covered Bonds

There is no legislation as of now; however, the following practices can be used:

  • Consistency in all the procedural aspects by all the issuers. For this, some specific standards can be laid out in the financial market.

  • There will be the use of similar templates at the time of making documents for issuing covered bonds. This would make the identification and the regulatory applications relating to the covered bonds simpler.

  • There will be an issuance of a covered bond model with a Special Purpose Vehicle(SPV).

  • There should be standardized rules with respect to SPV, SEBI registration, regulatory controls, maturity period, lending institutions requirements, security, collateral, over-collateralization, disclosure requirements, and other associated factors.

Introducing Regulatory Framework for Covered Bond in India

The National Housing Bank in its Working Group had featured “Covered Bonds” as one of the measures for strengthening the association between the Indian capital market and housing finance segment.

  • According to the Working Group report, a consultation paper had been issued which gave a proposal outline for Covered Bond issuance by the Housing Finance Corporations. The proposal which consisted of the draft guidelines was also discussed with the Reserve Bank of India (RBI), whereby it was advocated that the Banks would act as Investors/Issuers in Covered Bonds.

  • RBI welcomed the concept of the Covered Bonds introduction as it would provide new funding ways in the financial markets in India. However, it has been featured that there is a requirement of legal precision and risk management to successfully issue covered bonds in the market.

  • SEBI has also provided its confirmation with respect to covered bonds that they would come within the “Bonds” purview as specified in Section 2(h)(i) of the Securities Contracts (Regulations) Act, 1956.

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