Bonds
The concept of covered bonds has existed for about 200 years. This instrument was initiated by Frederick the Great of Prussia (Germany), with the creation of “Pfandbriefe.” The underlying idea was to help project financing. Typically, a bank issuing pfandbriefe bonds would be able to collateralize the bonds with some underlying assets already on its balance sheet.
In simple terms, a covered bond is a financial product whose creditors are benefiting from a pledge. This pledge usually corresponds to mortgage or public sector loans that are on the balance sheet of the issuing bank.
This product has remained a pure German instrument until recently, with mostly German investors purchasing local pfandbriefe issuance. Due to the globalization of the Western European economies as well as to the rising appetite of non-German investors for this kind of very secured product, other countries have enacted laws to replicate the concept, among which the French with “Obligations Foncières” or the Spanish with “Cédulas.” New jurisdictions continue to expand the universe of covered bonds, with legal and regulatory frameworks being amended to facilitate this development.
Apart from Germany, the fastest growing markets at the moment are the United Kingdom, with its Structured covered bonds, the Netherlands and, more recently, Italy. In the Nordic countries, regulation has even widened the scope of the product. Covered Bonds may, for instance, be collateralized by shipping loans.
Let us clarify first the distinction between Pfandbriefe-like Covered Bonds and Structured Covered Bonds:
♦ Pfandbriefe-like Covered Bonds are bonds backed by mortgage or public sector assets in a well-defined regulatory environment. Practically, the local Financial Code/Act clearly sets the rules applicable to the product.
♦ Structured Covered Bonds are issued in jurisdictions where there is no specifically adjusted regulatory framework. The robustness underlying this more recent type of product, such as the bonds issued in the United Kingdom, relies on a pure contractual basis and on legal opinions related to the case of insolvency of the issuing bank.
In both cases, the principle is that, upon insolvency of the issuing bank, a trustee (or administrator) would be appointed to service the registered cover pool* and that such a pool would be segregated from the other assets on the balance sheet of the bankrupt bank.