S&P Global Ratings' Covered Bonds Primer June 20, 2019 This covered bonds primer provides a comprehensive guide to the fundamentals and key features PRIMARY CREDIT ANALYSTS of the product. Antonio Farina Madrid Let's start with an obvious question… (34) 91-788-7226 antonio.farina @spglobal.com What Is A Covered Bond? Marta Escutia A covered bond is a debt instrument secured by a cover pool of assets. As long as the issuer is Madrid + 34 91 788 7225 solvent, it is obliged to repay its covered bonds in full on their scheduled maturity dates. If the marta.escutia issuer is insolvent, the proceeds from the cover pool assets will be used to repay the bonds. @spglobal.com Covered bonds were first introduced in Prussia in 1769 by Frederick the Great, and in Denmark in ANALYTICAL MANAGER 1797. France issued the first "obligations foncieres" in 1852. Despite such a long history, it was Barbara Florian not until the end of the twentieth century that the size and geographic scope of this market Milan broadened considerably, boosted by the introduction of "jumbo" covered bonds in 1995, the (39) 02-72111-265 introduction of the euro in 1999, and the approval of dedicated legislative frameworks in a number barbara.florian @spglobal.com of new countries. Figure 1 www.spglobal.com/ratingsdirect June 20, 2019 1 S&P Global Ratings' Covered Bonds Primer Key Features Of Covered Bonds - The bond is issued by--or bondholders otherwise have full recourse to--a credit institution which is subject to public supervision and regulation. - Bondholders have a claim against a cover pool of financial assets with a higher priority than the credit institution's unsecured creditors. - The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the covered bondholders' claims at all times. - The credit institution's obligations in respect of the cover pool are supervised by public or other independent bodies. Source: European Covered Bond Council. The great financial crisis and the European sovereign debt crisis proved that covered bonds can be a resilient source of funding even in times of wider market turmoil, and the amount of outstanding covered bonds peaked in 2012. Even in the countries most affected by the crisis, such as Italy and Spain, banks were able to access the covered bond market, despite other sources of wholesale funding evaporating. Issuers and regulators outside the traditional European markets duly noted banks' ability to issue covered bonds, and expedited the approval or the amendment of legislation governing the issuance of covered bonds. While at the beginning of this century more than 90% of outstanding covered bonds were still issued out of Germany, Denmark and France, their share had decreased to about 44% by 2017. Chart 1 www.spglobal.com/ratingsdirect June 20, 2019 2 S&P Global Ratings' Covered Bonds Primer What Are The Benefits Of Covered Bonds? Covered bonds offer significant benefits to issuers and investors, which explain their growing popularity. Figure 2 www.spglobal.com/ratingsdirect June 20, 2019 3 S&P Global Ratings' Covered Bonds Primer Covered bonds play a systemically important role in Europe While retail deposits still fund most mortgage lending in Europe, covered bonds play an increasingly systemic role. Chart 2 www.spglobal.com/ratingsdirect June 20, 2019 4 S&P Global Ratings' Covered Bonds Primer Financial institutions are still the main investors in covered bonds While private banks and fund managers have historically been the main investors of covered bonds, central banks have played an increasingly important role, especially following the European Central Bank's decision to include them in its asset purchase program in 2014. Chart 3 Since financial institutions are the main investors in covered bonds, the legal and regulatory framework that supervises the financial sector's activity is uniquely important for this market. The Regulatory Framework Covered bonds enjoy favorable regulatory treatment compared to many other asset classes because of their systemic importance and the relatively low risk profile of the product. Table 1 Current EU Regulatory Framework Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive Article 52(4) provides a common definition for covered bonds Bank Recovery and Resolution Directive (BRRD) Article 44(2) exempts covered bonds from bail-in Capital Requirement Directive (CRR) Article 129 assigns low risk weights to covered bonds Liquidity Coverage Ratio (LCR) Delegated Act Articles 11 to 13 define covered bonds as highly liquid assets www.spglobal.com/ratingsdirect June 20, 2019 5 S&P Global Ratings' Covered Bonds Primer Table 1 Current EU Regulatory Framework (cont.) Solvency II Delegated Act Article 180(1) assigns low capital requirements for covered bonds held by insurance and reinsurance undertakings European Market Infrastructure Regulation (EMIR) Provides for a specific treatment of cover pool derivatives Covered Bonds Versus Securitization The recourse to the issuer and the consequent lack of risk transfer is the main difference between covered bonds and asset-backed securities, such as residential mortgage-backed securities (RMBS). Since in covered bonds the credit risk remains with the originator, it has a greater incentive to manage it prudently. Covered bond programs have dynamic cover pools so that assets that repay or which are no longer eligible are replaced, compared to RMBS where the pool is generally static and assets are not replaced. Finally, covered bonds tend to have bullet maturities, while in most RMBS principal collections are transferred directly to investors. Table 2 Key Differences Between Covered Bonds And RMBS Covered Bonds RMBS Debt type Typically direct bank debt Debt issued by an SPV Recourse to the originator Full recourse to the originator No Tranching All the bonds rank pari passu Senior and subordinated notes On/off balance sheet On the balance sheet of the originator Off the balance sheet of the originator Asset pool Dynamic pool Typically static pool Debt redemption profile Typically bullet Typically pass-through Replacement of assets Nonperforming assets typically replaced No replacement of nonperforming assets Covered Bond Program Structures Legislation-enabled and structured covered bonds Initially banks only issued covered bonds in accordance with a dedicated legal framework (legislation-enabled covered bonds). The legal framework would define the covered bond programs' main characteristics, such as eligible assets, minimum overcollateralization, and monitoring. From 2003, issuers in certain countries without domestic covered bond legislation, such as the U.K. or the Netherlands, established programs that replicated the main features of legislation-enabled covered bonds by means of contractual arrangements (structured covered bond programs). Issuers also sometimes preferred contractual arrangements to gain greater flexibility outside of an established legal framework. The legal framework, contractual provisions, or a combination of the two need to effectively isolate www.spglobal.com/ratingsdirect June 20, 2019 6 S&P Global Ratings' Covered Bonds Primer the cover pool assets for the benefit of covered bondholders, so that covered bond payments continue on their scheduled maturity dates. The issuer can achieve this isolation by setting up an "on-balance sheet" covered bond program or through an "off-balance sheet" program. In "on-balance sheet" programs, the segregation is achieved on the issuer's balance sheet or by the issuer setting up a distinct subsidiary to hold the cover pool assets (specialist bank model). Covered bond markets with this structure include Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Korea, Luxemburg, Norway Portugal, Spain, and Sweden. Figure 3 In "off-balance sheet" programs, the cover pool is isolated in a special purpose-entity (SPE). Structured covered bond programs are typically set up in this way. However, there are instances of legislation-enabled covered bonds that use the "off-balance sheet" structure, such as in Italy. Markets setting up SPEs include Australia, Canada, France, Italy, the Netherlands, New Zealand, Singapore, Switzerland, and the U.K. Figure 4 www.spglobal.com/ratingsdirect June 20, 2019 7 S&P Global Ratings' Covered Bonds Primer Participants There are various parties involved in the effective functioning of covered bond programs, with roles ranging from the origination of cover pool assets to the repayment of the covered bonds. The number and functions of the parties may vary by program. Figure 5 Maturity structures As long as the issuer is solvent, it is obliged to fully repay its covered bonds on their scheduled maturity dates. If the issuer is insolvent, it will apply the proceeds from the cover assets to repay the covered bonds. In a traditional "hard bullet" structure, the pool administrator may need to liquidate collateral to www.spglobal.com/ratingsdirect June 20, 2019 8 S&P Global Ratings' Covered Bonds Primer repay the bonds on time, on their scheduled maturity dates. By contrast, in a "soft bullet" structure, the pool administrator can extend the maturity date, typically by up to a year, before the covered bonds become due and payable. This postpones the liquidation of the assets, and can help avoid forced sales. Conditional pass-through (CPT) structures typically switch to a pass-through redemption profile after an issuer insolvency, when either the assets in the pool offer insufficient funds to repay the covered bonds, or a performance test has been breached. In a pass-through redemption, the issuer applies collections from the assets on each payment date to repay the principal on the notes, but the trustee does not need to liquidate the assets, because the maturity of the notes can be extended. The extension date typically depends on the remaining term of the assets, which could enable the issuer to hold the assets to maturity while retaining the option of liquidating assets in advance if market conditions are favorable.