The Covered Bond Squeeze Play

Posted by on 23 March 2009

From Andreas Jobst, John Kiff and Carolyne Spackman.

In Europe, covered bonds, often regarded as riskless as government debt, have provided banks with cost-efficient funding for over 200 years, and now constitute a $3 trillion market. However, after renewed financial market turbulence in September 2008, the primary market for covered bonds has virtually shut down as new issues have been squeezed out by state-guaranteed bonds and unsecured bank bonds (that also benefit from state rescue programs but provide a yield pickup). Meanwhile, secondary market prices of covered bonds remain depressed while credit spreads have been widening. This column reviews recent market developments during the current financial crisis and to assess the potential future of these important funding instruments.




Covered bonds help redress some of the fundamental incentive problems that contaminated the economic rationale of securitization. One of the key lessons learned from the “subprime crisis”, is the importance of loan originators keeping “skin in the game” in order to appropriately align their interests with those of structured credit product investors. Covered bond issuers are naturally incentivized to make and maintain good loans, because they remain ultimately responsible for the performance of the loans being funded.

In a move to stabilize credit markets afflicted by the demise of securitization, authorities in several countries have drawn up plans to encourage the issuance of covered bonds as an alternative source of capital markets-based funding. Paradoxically, however, general financial sector inventions aimed at unfreezing interbank lending markets (i.e., state guarantees of bank bonds) have seriously undermined the ability of lenders to use covered bonds to fill the void of unmet credit demand left by dysfunctional securitization markets.

A covered bond is a secured debt obligation collateralized by a dedicated reference portfolio of assets retained by the issuer (the “cover pool”).[ii] Issuers of covered bonds are fully liable up to their registered capital. Hence, this arrangement implies a double protection for investors. On the downside, covered bonds do not provide balance sheet leverage and regulatory capital relief normally associated with securitization.

In Europe, covered bonds have long been the preferred method of capital market-based mortgage refinancing. While the German Pfandbrief (literally “letter of pledge”) is the eponym of the covered mortgage bond, similar covered bond frameworks have evolved in other European countries, especially in France, Spain and the Scandinavian countries over the last 200 years.[iii] The creation of the single currency improved liquidity and gave the market added momentum. Covered mortgage bondsnow constitute a US$3 trillion market (equivalent to around 40% of European GDP) and are the main source of financing for real estate loans and municipal debt.[iv]Some 30 countries have either introduced, or are considering introducing, legal provisions governing the issue of covered bonds.

About 40 percent of total outstanding bonds are “jumbo” issues, which are typically large (at least €1 billion outstanding) and to which a minimum number of market makers have committed to quote continuous two-way prices.  


Current market conditions

As the credit crisis has sapped investor appetite for securitization transactions, several issuers in North America have been reconsidering covered mortgage bonds. Washington Mutual and Bank of America have completed their first covered bond deals in 2007, and Citibank, Wells Fargo, and JPMorgan have expressed interest in entering this market. In Canada, the Bank of Montreal, Canadian Imperial Bank of Commerce, and the Royal Bank of Canada have together issued about €5 billion covered bonds.

With market ruptures that caused by the headlong flight to safety during the initial phase of the credit crisis receding only slowly, banks’ ability to issue covered bonds is severely impaired by the impact of government guarantees, rating changes and de-leveraging of the financial sector. Demand for bank term debt has largely disappeared as some traditional investors scale back their balance sheets in the course of general de-leveraging. Redemption pressures exacerbate the decline in demand. Hence, there has been negligible jumbo covered bond issuance since September.[v]

Also state guaranteed bonds have undermined demand for covered bonds because they are eligible for a zero risk weight under Basel II and the European Capital Requirements Directive, versus a 10% risk weight for covered bonds. Furthermore, the rating agencies have tightened their criteria for AAA covered bonds issued by some banks, driving up issuance spreads and overcollateralization requirements as banks anticipate higher leverage ratios (together with the general market focus on equity/assets and similar ratios).

Historically, covered bond spreads have been little affected by deteriorating issuer creditworthiness, or by covered pool asset credit quality deterioration. All of that has changed since July 2007, although spreads on covered bonds that are issued under robust institutional and legal frameworks, such as those that apply to German Pfandbriefe, have remained relatively narrow. The same cannot be said of “structured” covered bonds, such as those issued by U.K. and U.S. banks, in which all of the terms and conditions are defined in the issue-specific legal documentation.

Recent U.K. FSA actions to provide some covered bond legal and regulatory framework clarity will likely put the U.K market on firm footing when investor appetite returns. On one hand, in October, the FSA indicated that it would be looking to be wary of any covered bond issuance or asset encumbrance that led to any structural subordination of depositors. In effect, this would have reduced covered bond usefulness to being Special Liquidity Scheme collateral. However, in mid-November, the FSA reversed its initial position by approving seven major banks as regulated covered bond issuers, making covered bonds eligible for a reduced risk weighting and the ECB Liquidity Scheme as category II collateral.

Nevertheless, until the impact of government guarantees is absorbed in fixed income markets, jumbo covered bond issuance will not price competitively with respect to other sources of funding, and primary markets for covered bonds are likely to remain quiet. Given that many state programs guarantee bonds with maturities up to 5 years, and some for only 2-3 years,[vi] demand for state guaranteed bonds should be expected to increase in the nearer term, declining as the guarantees approach expiration. Also, as new economic information demonstrates, we have yet to see a considerable abatement of systemic risk, and hence, covered bond spreads continue to widen, discouraging new jumbo issuance.


Assessment and policy implications

But, as systemic risk is gradually transferred from the private sector to the state, and the state’s absorptive capacity for risk diminishes, state guaranteed bond spreads and covered bond spreads might begin to converge, especially in smaller countries with relatively large financial sectors, such as Ireland. This could occur as countries that have increased their public sector spending face decreasing capacity to honor their obligations under the guarantees, while investors reconsider the value that covered bonds provide in the form of collateralization. Covered bonds may remain an attractive option for individual banks to transition back to longer-dated funding. Although we do not expect a robust return to covered bond issuance in the near term, we may see some patchy issuance as the market continues to distinguish among jurisdictions and issuers. [vii]

In the meanwhile, covered bond issuance can complement direct government and central bank support measures to establish financial stability and provide banks with alternatives (to securitization) capital markets-based funding sources. Covered bond markets can form an essential part of private sector solutions aimed at building confidence and enhancing liquidity in the system when unsecured credit is scarce. For instance, Switzerland aims to boost liquidity in the interbank market by channeling funds from small, local banks increasingly favored by depositors, to large, cash-starved banks through the existing covered bond market. This initiative is supported by a relaxation of capital requirements for issuers’ covered bonds, which is expected to trigger an additional volume of around 20 billion Swiss francs ($17 billion) of debt issuance.[viii]


Andreas Jobst, John Kiff and Carolyne Spackman,
International Monetary Fund,



[i] Investors have no direct ownership rights to the underlying cover pool assets, which generally change over the life of the covered bonds as assets are substituted for those that have prepaid.

[ii] This preferred claim of the covered bond holders is why national authorities often place limits on bank covered bond issuance. For example, Canadian bank issuance cannot exceed four percent of total assets.

[iii] For more on covered bond history, see Jobst, Andreas A., “A Primer on Structured Finance,” Journal of Derivatives and Hedge Funds, Vol. 13, No. 3, pp. 199-213).

[iv] By comparison, the total outstanding balance of all U.S. securitization transactions at end-2007 stood at $6.6 trillion, while European securitization totaled $1.3 trillion (of which $791 billion were mortgage-backed securities).

[v] Although the jumbo Pfandbrief market remains closed, private placements continue to get done.

[vi] The state guarantees in Canada and the UK are for only three years; however, in January, Germany announced an extension of its state guarantee from 3 to 5 years (after which their covered bond spreads widened further). Other countries may follow these extensions, further stalling any near-term recovery of covered bond markets.

[vii] Given the effect of state-guaranteed bonds, a real return may not be possible until 2010-2011.

[viii] Particularly, the large banks, which lost more than 25 percent of their deposit base during the crisis, benefit from this scheme. In December, UBS received CHF2 billion in liquidity through a transaction involving Swiss covered bonds.