What is a Covered Bond?

Covered bonds are typically backed by pools of residential mortgages. They’ve become increasingly popular owing to their high level of safety and credit ratings.

Covered bonds are a relatively new addition to the Canadian bond market that provide a relatively inexpensive source of mortgage funds. But they have been growing in popularity because of their high credit ratings and level of safety.

That’s because the security is usually backed up by pools of mortgages, with the bonds ‘covered’ by the cash flows of the underlying instruments.

Public sector loans make up some of the assets, but the covered bond collateral is mainly made up of uninsured Canadian residential mortgages.

Covered bonds had their genesis in Europe during the 18th century at the end of the Seven Years War when the Prussian King, Frederick the Great, introduced measures for the nobility to have an easier time accessing credit. Public law associations were set up and debentures were issued that gave the creditor a direct claim over estates that had been pledged for security. This morphed into the present day “pfandbrief,” a mostly triple-AAA rated German bond debenture that has become the model for many covered bond schemes in Europe and elsewhere.

In Canada, the issuance of covered bonds started in 2007. But they really didn’t go anywhere as the U.S. housing market was collapsing around that time, followed by the deep financial crisis of 2008, which was fuelled in part by plummeting credit ratings for a variety of other securitized mortgage assets.

The issuance of covered bonds really took off in 2012 after Canada Mortgage and Housing Corp. (CMHC) established new guidelines for issuing them. CMHC is a Crown corporation, established in 1946 to administer the National Housing Act, and is best known as the vehicle which sells insurance to Canadian residential mortgage lenders.

In 2012, CMHC set up the Canadian Registered Covered Bond Programs Guide, a registry that financial institutions use to apply for registration and issue their covered bonds.

Among other things, the registry provides protection for the covered bond buyer, “resulting in increased certainty for investors with respect to the cover pool of collateral in the event of a default.”

CMHC also says the legal framework of the registry provides Canadian financial issuers access to a broader investor base. That’s because some international investors are restricted from buying bonds that are issued under a non-legislative framework.

And the registry will also tell the investor about registered issuers that have been suspended from the program.

There are restrictions on the quantity of covered bonds a financial institution can offer on the market. The Office of the Superintendent of Financial Institutions limits the amount any one financial institution can issue to four per cent of that firm’s assets.

Covered bonds do share a similarity with mortgage-backed securities, since both are backed by a pool of loans secured by property mortgages. But covered bonds offer increased protection for the buyer as the underlying loan portfolio stays on the financial institution’s books. That gives the investor recourse against the issuer and the underlying collateral of the covered bond.

In the case of MBSs, that’s not the case. When these securities are issued – through a special purpose entity of SPE – the bank ceases to have the mortgage pool on their books.

4 years ago