By Jason Voss, CFA
Risky debt dominates the world of fixed income with most securities only offering a legal promise to pay interest and to pay back principal to investors. These uncollateralized, unsecured bonds are nothing more than glorified IOUs.
But what if fixed income instruments were backed with actual collateral? You might say such an instrument already exists and is called an asset-backed security (ABS). But even ABS suffer from a risk I will call "talk to the hand." This is because most ABS are created by third parties and sold to investors with the issuers retaining no future obligation to buyers once the ABS is collateralized and sold. So if buyers lose money they cannot take their grievances to the issuer, and instead must "talk to the [issuer's] hand," the notorious ABS "servicer."
What if bonds were not just collateralized but remained the obligation of issuers? Such a security would offer two layers of protection to investors: an issuer with a vested interest in the performance of the security and and assets to back up investors should the issuer default. In fact, such a security already exists and is known as a covered bond. In fact, history proves that buyers of covered bonds usually get paid back in full in the event of default, whereas issuers in other securities usually experience significant haircuts.
Covered bonds are not the result of a recent wonky financial engineers confab. No, these instruments have been around since 1769 with the creation of the Pfandbriefe in Prussia by Frederick the Great. Another early example of a covered bond is Copenhagen's 1787 Realkreditobligationer covered bonds sold to finance the rebuilding of their fire-devastated city. French covered bonds were first issued in 1852 with the creation of obligations foncières.
See a trend? Europeans did and do dominate the world of covered bonds. Why is this? One important reason is that 25 European jurisdictions have covered bond laws on the books. This is important, because covered bonds have a legal structure that creates securities with important investor features, such as issuers being required to keep covered bonds on their books - so no securitization - and a requirement that the debts be collateralized. Because of Europe's long history with these collateralized senior secured debt instruments, there are many established issuers - more than 300 at last count - as well as deep, liquid markets.
Whereas, in the United States, national covered bonds legislation still does not exist. This means that covered bonds in the United States are issued under the Securities and Exchange Commission (SEC) 144(a) private placement rules or under rule 3(a)2 provisions. The lack of registration in the United States limits the number of prospective buyers. In turn, this makes covered bonds less attractive for issuers seeking high numbers of bidders to lower their financing costs. In turn, this also means that Wall Street banks do not see enough of a market to justify holding an inventory of the bonds to facilitate trading and additional liquidity.
Another reason for covered bond success in Europe is that they satisfy bank capital requirements. Consequently they are a coveted asset to own for Europe's quality capital-starved financial institutions. Meanwhile, the Federal Reserve Board (FRB) and Federal Deposit Insurance Corporation (FDIC) have yet to recognize covered bonds as a valid source of bank capital.
Importantly, covered bonds are also popular in Canada, Australia, and Scandanavia, and for the same reasons described above. But the United States appears to be awakening to the possibilities of these instruments. In fact, there are now 20 issuers of covered bonds in the United States - nine of them being foreign issuers of dollar-denominated debt - with monthly trading now amounting to $100 billion. Furthermore, the very first registered issue was priced just recently after several years of effort. Dealers also report making money in the instruments. This incentivizes investment banks to hold a covered bonds inventory, as well as allowing them to use covered bonds as hedges. In other words, a liquid US covered bond market seems to be forming slowly.
Last, one sure sign of issuer and investor interest is the development of, and strong attendance at, an industry conference. Just such a conference was recently held in New York City: IMN's Fourth Annual Covered Bonds the Americas Conference. Here participants were a mix of the curious, the active participant, and the full-fledged booster. Yet all seemed to agree that covered bonds will remain an important source of capital in Europe in the coming decades and securities sure to continue to win US investor support.