What is a covered bond

Covered bonds are generally long-term fixed-interest bonds issued by a covered bond bank on the basis of the Pfandbrief Act (PfandBG). The covered bond is considered a particularly secure investment, because in the - unlikely - event of insolvency of a covered bond institution the bank not only answers to covered bond creditors with its equity but also with the so-called cover pool.

Covered bond creditors are satisfied preferentially before other creditors of a covered bond bank. Covered bonds are usually issued as bearer securities and are therefore tradable securities. In part they are also issued as registered securities, where a transfer is possible only with involvement of the issuer. These papers are primarily aimed at institutional investors such as life insurers and pension funds.

Covered bond: Historical development

The history of covered bonds began more than two hundred years ago in Prussia, where they were established in 1769 by a decree of Frederick the Great. They served as a financing instrument for the so-called Landschaften. These were regional compulsory associations of large noble landowners, whose purpose was to provide agricultural land credits. The covered bonds issued by the Landschaften were secured by mortgaged real estate.

In the mid-19th century the first mortgage banks were able to refinance themselves with covered bonds secured by land charges. With the Mortgage Bank Act, which came into force on 1 January 1900, a uniform legal basis for covered bond issuances was created for all of Germany after the founding of the German Empire.

Legal foundations of the covered bond

Further regulations followed in 1927 with the "Law on covered bonds and related debt securities of public-law credit institutions" (ÖPG) and in 1933 with the "Law on ship covered bond banks". In the course of the elimination of state guarantees for public-law banks - the so-called guarantor liability - a statutory reorganization of covered bonds took place in 2005. The previous provisions on covered bonds that had been contained in various laws were consolidated in the new Pfandbrief Act. The Mortgage Bank Act, the ÖPG and the ship bank law thus ceased to apply.

The PfandBG became effective on 1 July 2005; with an amendment to the PfandBG on 26 March 2009 the aircraft covered bond was additionally introduced as a new type of covered bond. Covered bonds or covered-bond-like structures also exist in other European countries. Internationally these are referred to as "covered bonds." The German Pfandbrief differs from the covered bonds in many other countries mainly through its legal basis and rules for determining lending values as well as state supervision.

Special requirements for covered bonds

In Germany covered bonds may only be issued by covered bond banks. Credit institutions that wish to issue covered bonds require a special permit from the Federal Financial Supervisory Authority (BaFin). The license is granted only if the credit institution intends to operate the covered bond business on a sustainable basis and establishes appropriate risk control systems.

Covered bonds must—unlike other bonds—be secured by a cover pool in accordance with the requirements of the PfandBG. Depending on the type of collateral, the following types of covered bonds are distinguished:

• Mortgage covered bonds: land charges (mortgages, land liens) on mortgaged properties serve as collateral;
• Public covered bonds (formerly known as municipal debentures): claims against the public sector serve as collateral;
• Ship covered bonds: are covered by ship mortgages registered in a special ship register;
• Aircraft covered bonds: the collateral is provided by aircraft mortgages registered in a public register.

In the event of insolvency the holders of covered bonds are satisfied from the cover pool preferentially before other creditors.

Covered bond banks

Covered bond banks must observe special requirements when granting loans eligible for inclusion in the cover pool. The lending values for the mortgaged real estate, ships or aircraft must be determined under the principles of prudence and permanence by experts. The loans eligible for the cover pool must not exceed 60% of the determined lending value.

A trustee appointed by BaFin monitors compliance with the requirements associated with cover pool eligibility. In addition to general banking supervision, covered bond banks are subject to special supervision by BaFin. A statutory audit of the cover pool assets takes place at least every two years.

There are also special transparency requirements: covered bond institutions must publish a quarterly report on the composition of the cover pool. The licensing requirement and the trustee supervision, the cover pool, the lending limit and the prudent lending valuation make covered bonds particularly secure investments.

Covered bonds are approved investments in guardianship relationships (prudential investments), can serve as loan collateral (Lombard eligibility) and can be possible components of an insurer's cover pool (cover pool eligibility). Covered bond banks generally pursue a rather conservative business policy; the last insolvency of a covered bond bank occurred in 1901.

In external ratings by rating agencies covered bond institutions often achieve top marks in terms of their creditworthiness.

The covered bond as an investment

Covered bonds typically offer a somewhat higher yield than German federal bonds or bonds of other public-law bodies, but due to their dual security (creditworthiness of the issuing institution and cover pool) they have comparable safety. Compared with other corporate bonds, which are generally considered less secure, their yield is lower.

The yield differential to other public bonds is largely due to the lower fungibility of covered bonds. For many covered bonds there is hardly a functioning market through which a purchase or sale is possible.

Investors in covered bonds benefit from the high security, the regular interest payments (semi-annually or annually) and the somewhat higher yields. A disadvantage is often the low marketability. Covered bonds are therefore more suitable as long-term investments. Those who sell their covered bonds before maturity may, in times of rising interest rates, have to reckon with significant price losses.

Covered bonds are thus particularly suitable for medium- to long-term, safety-oriented investors who intend to hold their securities until maturity. An alternative investment is covered bond funds. These are open-ended investment funds that invest broadly in covered bonds and similar securities. The investor can benefit here from the yield and safety advantages of covered bonds while gaining on average higher marketability.

Jumbo covered bonds

Since the mid-1990s so-called jumbo covered bonds have established themselves on the market. The term jumbo covered bond is not a legal term but has emerged as a designation for certain types of covered bonds with a large issuance volume.

Market liquidity plays a special role for jumbo covered bonds; they must therefore have a minimum volume of one billion euros. In addition, a so-called market-making arrangement must be agreed for such a jumbo covered bond. At least five banks accompanying the issuance must commit to the issuer to ensure a functioning market for the issued covered bond.

The covered bond must be placed promptly on an organized market within the EU or the EEA. Jumbo covered bonds are primarily aimed at international institutional investors. Thanks to market-making, however, retail investors also get the opportunity to buy or sell jumbo covered bonds on a daily exchange basis.

The Deutsche Börse calculates a special covered bond index, the 'eb.rexx® Jumbo Covered Bonds', from the 25 most liquid jumbo covered bonds on the electronic trading platform EurexBonds. It shows the average price development in the covered bond market. With a market volume of approx. 850 billion euros, the covered bond market is, after the market for public bonds, the second-largest market segment for fixed-income securities in Germany.