FREQUENTLY ASKED QUE STION S A B O U T COVERED BONDS participation in the market has been rapidly Background expanding with the recent passage of legislation What are covered bonds? bolstering its popularity. See “Covered Bond Structure Outside of the United States.” Although Covered bonds are debt obligations that have European issuances are currently at historic lows, recourse either to the issuing entity or to an affiliated non-U.S. issuers of covered bonds issued almost $50 group to which the issuing entity belongs, or both. billion of covered bonds into the U.S. in 2012, with Upon an issuer default, covered bond holders also more than $110 billion of covered bonds in the U.S. have recourse to a pool of collateral (known as the outstanding at year-end. “cover pool”), separate from the issuer’s other assets. How are covered bonds issued? What type of assets can make up the cover pool? Covered bonds can be issued as a single issuance or The cover pool usually consists of high quality assets, as a program. Under the Securities Act of 1933, including residential mortgages, public debt, or ship covered bonds are regulated as securities and must be loans. Cash, or cash equivalents, also may serve as registered under the Securities Act or exempt from cover pool collateral. registration. U.S. covered bond programs often rely Are covered bonds a new product? on the Rule 144A exemption; however, on July 30, Although relatively new to the United States, covered 2012, the Royal Bank of Canada obtained SEC bonds are not a new product. Covered bonds have approval for a registration statement for its covered been used to raise capital in Europe since 1769, when bond program. In 2013, other covered bond issuers the first covered bond was issued in Prussia to have begun submitting registration statements to the finance agriculture. Germany, France, and Spain SEC for their programs in an attempt to expand the have large covered bond markets aided by specific U.S. covered bond investor base. legislation that prescribes a framework for the issuance of covered bonds. The United Kingdom’s What type of bond is issued? might not reach the covered bond holders; Covered bonds generally are fixed rate bonds with a and maturity of no less than one year and no more than 30 protection against borrowers’ attempts to set years. The bonds are low risk yield-bearing products off their debt against any receivable they having long maturities. have against the issuer. Who invests in covered bonds? Central banks, pension funds, insurance companies, Covered Bond Structure in the United States asset managers, bank treasuries, and other institutional investors seeking a low risk yield- How are covered bonds structured? bearing product with a long maturity invest in There are two ways to structure covered bonds. The covered bonds. depository institution can issue the covered bonds directly, or a special purpose vehicle (SPV) can be What factors are considered when rating agencies established to act as issuer or as guarantor. See “How rate covered bonds? are covered bonds structured when the depository Rating agencies treat covered bonds as a hybrid institution issues the covered bonds directly?” and instrument. The ratings analysis is based in part on “How are covered bonds structured when a SPV is the credit and rating of the sponsor entity and in part established to issue or guarantee the covered bonds?” on the collateral (or cover pool). Regardless of structure, there are three general In evaluating the cover pool in covered bond principles of all covered bonds. The covered bonds issuances, rating agencies consider the following must be secured by high quality assets; management factors: of the cover pool must be supervised; and investors the effective segregation of the cover assets are first in priority upon an issuer’s insolvency. from the claims of other creditors of the Whether contractual or statutory, there must be a issuer; framework in place that protects the cover pool from the immunity of excess over-collateralization unsecured creditor claims and directs payments to against the claims of other creditors of the covered bond holders upon a bankruptcy. issuer; Who holds the collateral and protects the investors the bankruptcy-remoteness of the collateral under the U.S. covered bond structure? posted by swap counterparties; There are two trustees under the U.S. covered bond provisions against the risk that the cover structure. The mortgage bond indenture trustee is an pool’s cash flows could be commingled with independent trustee designated by the mortgage other revenues of the insolvent issuer and bond issuer. This trustee represents the interests of the mortgage bond holder and enforces its rights if 2 the mortgage bond issuer defaults. The covered bond compliance test results in an event of default that indenture trustee is an independent trustee would trigger acceleration of the covered bonds. designated by the covered bond issuer who Additional events of default include interest and represents the interests of investors and enforces the principal payment failures and the occurrence of investors’ rights if the covered bond issuer defaults. certain insolvency events. If the covered bonds are See “How are covered bonds structured when a SPV accelerated, the covered bond indenture trustee can is established to issue or guarantee the covered cause the covered bond issuer to liquidate the bonds?” for an explanation of the roles of the collateral to make payments due under the covered mortgage bond issuer and the covered bond issuer bond. See “What happens to payment flows if there and their respective obligations. is a mortgage bond acceleration?” and “What happens to payment flows if there is a covered bond How are investors protected under the U.S. covered acceleration?” bond structure? In the event of a mortgage bond issuer default, the How are covered bonds structured when the covered bond indenture trustee, on behalf of covered depository institution issues the covered bonds bond holders, will deposit all mortgage bond directly? payments and related proceeds into a guaranteed Direct issuance is used in most non-U.S. countries investment contract (GIC), or other arrangement with specific covered bond legislation. These whereby the proceeds of the cover pool are invested transactions are structured so that the depository with, or by, one or more financially sound institution originating the mortgage loans making up counterparties. The purpose of entering into a GIC is the cover pool is also the issuer of the covered bonds to ensure continued timely payments to the covered and retains the assets in the cover pool at the issuing bond holders and avoid acceleration of payment entity level. Legislation in some European countries under the covered bonds. Mortgage bond issuer provides exceptions for covered bonds in the event of events of default include failure to make timely bankruptcy. Specifically, in the event of an issuer payment of interest and principal, failure to satisfy insolvency, covered bond holders have priority rights the asset coverage test, and the occurrence of certain over the cover pool assets. insolvency events. Below is a diagram of the direct issuance structure The covered bond indenture trustee performs a where the depository institution issues the covered monthly proceeds compliance test to ensure there are bonds. adequate proceeds available to make timely payments on the covered bonds. See “What is a proceeds compliance test?” Failure to satisfy the proceeds 3 How are covered bonds structured when a SPV is The cover pool assets (the mortgage loans) remain established to issue or guarantee the covered bonds? with the depository institution. Both of these The two-tier structure used in the United Kingdom structures provide bankruptcy protection similar to and Canada (both of which retained such structure in that granted by statutes implementing direct issuance their covered bond legislation when passed) provide structures in the EU. for the depository institution originating the The proceeds from selling covered bonds are used mortgage loans to sell the mortgage loans to a SPV. by the covered bond issuer to purchase the mortgage The depository institution issues the covered bonds bonds, which are secured as a separate pool of and the SPV guarantees the payment of the covered mortgages on the bank’s balance sheet. The covered bonds, secured by the mortgage loans. The synthetic bond issuer, as the holder of the mortgage bonds, has two-tier structure used in the United States provides a perfected security interest in the mortgage pool. for the depository institution originating the Below is a diagram of the synthetic two-tier mortgage loans to sell mortgage-backed bonds to a structure used in the United States where a SPV is SPV established to act as issuer of the covered bonds. established to issue covered bonds. 4 for a non-U.S. covered bond is a direct issuance Covered Bond Structure Outside of the United States single-tier structure. Although legislation varies in What is the general non-U.S. regulatory framework each jurisdiction, there are two key factors that enable for covered bond issuances? a covered bond market to flourish outside of the U.S.: legislation providing for special treatment under At year-end 2012, there were 37 countries with bankruptcy law in the event of an issuer insolvency covered bond legislation, including France, Germany, for the benefit of covered bond holders; and special Italy, Spain, Portugal, Sweden, Denmark, Norway, treatment under the banking laws that provide Finland, United Kingdom, Australia, and New favorable risk weighting in comparison to the issuer’s Zealand. In December 2012, Canada adopted a two- unsecured debt for the benefit of covered bond tier framework similar to the one utilized in the issuers.