Covered Bonds 101: A Low-Risk Investment For Steady Returns

In an uncertain market with rising economic concerns, investors seek stable, low-risk investment options that offer predictable returns without sacrificing yield. One such option is covered bonds, a secure debt instrument issued by banks and NBFCs to raise capital while ensuring investor protection.

Covered bonds stand out due to their dual recourse protection, meaning investors have a claim both on the issuing institution and the underlying asset pool. This makes them an attractive choice for risk-averse investors looking for a balance of security and steady returns.

Read on to understand how covered bonds work, their benefits, and why they could be a valuable addition to your investment portfolio.

What Are Covered Bonds?

Covered bonds are a kind of debt security that is issued by banks. Such securities are backed by a pool of assets. Unlike ordinary bonds, the covered bonds are not removed from the issuer's balance sheet. This way, the investors enjoy dual protection - the rights of the investors against the issuing bank as well as the underlying assets.

The collateral assets are usually good-quality loans, including home or commercial property loans. These loans produce cash flow, which enables the bank to service interest and repay investors. If a bank is in financial difficulty, the pool of collateral guarantees investors are still paid. 

This arrangement is profitable for investors (who receive secured returns through bond payments) and the bank (which mobilises funds without compromising asset control). 

There are two types of covered bonds – legislative and contractual. 

In India, there is no legislative framework for covered bonds so far. Therefore, all the covered bonds in India are contractual bonds regulated by a contract between the investor and the bond issuer. 

Example Of A Covered Bond

Consider XYZ Bank, a leading Indian bank, which requires raising INR 500 crore by way of issuing covered bonds. To provide security for the investment, it creates and issues home loans of INR 600 crore as collateral. The borrowers are those who pay their EMIs regularly.

Investors buy XYZ Bank's covered bonds knowing that even if the bank is financially troubled, the  INR 600 crore home loan pool will ensure their repayment. The bank then uses the funds raised to give more home loans, keeping the lending cycle going.

Recommended Reading: Why Are Senior Secured Bonds Preferred By Risk-Averse Investors ?

Benefits Of Investing In Covered Bonds

Covered bonds are a safe investment opportunity with several advantages for investors. 

1. Investor Protection

Investors can have a direct claim against the issuing bank and a second claim over the pool of collateral. Investors get their payments in the event of bank default due to the underlying collateral. 

2. Low Risk And Steady Returns

Since covered bonds are collateralized with high-grade collateral such as home loans and public sector loans, they yield consistent returns and stable income. The assets are cash-generating, thus promoting timely payment of interest. Covered bonds are also subject to lower default risk than business debt, making them a safer investment.

3. Protection By The Regulator

Most nations, including India, have laws to guarantee tight regulation of covered bonds. Such regulations compel banks to keep adequate collateral and update the asset pool periodically, minimising investor risk.

4. Liquidity And Market Access

Covered bonds are very liquid; investors can readily sell or purchase them in secondary markets. Because the bonds are regarded as low-risk, they tend to appeal to institutional investors, enhancing liquidity even further.

5. Diversification

Covered bond investment provides investors with an opportunity to diversify their portfolio with a low-risk investment. In contrast to corporate bonds or stocks, covered bonds are not sensitive to economic variations, thereby enabling investors to offset risk.

6. Greater Liquidity For Banks

Covered bonds create better cash flow for banks, but they indirectly benefit the market. Banks can borrow money at reduced interest rates using covered bonds to offer better loan terms. This strengthens the financial system and promotes credit availability.

Key Features Of Covered Bonds

Some of the key features that make covered bonds attractive for investors are:

1. Dual Recourse Structure: Covered bonds give investors two layers of security.

2. Issuer's Obligation: The bank issuing the bond is liable to pay back investors.

3. Collateral Backing: In case of default by the bank, the pool of assets (e.g., home loans) guarantees investors continue to get paid.

Regulatory Framework For Covered Bonds

Covered bonds are subjected to stringent rules that protect investors. In most nations, including India, banks are required to hold a high-quality pool of collateral. They must monitor and renew the asset pool periodically.

A. Dynamic Collateral Management

Banks have to actively maintain the pool of assets so that it always provides coverage for the value of the bond. If underperforming assets depreciate, banks have to use them as replacements with new loans while keeping investors safe. 

Banks also add more assets as security than the loan’s value, a practice known as overcollateralisation. This keeps investors safe even when some of the loans in the pool fail to be repaid.
B. Long-Term Viability

Covered bonds usually have longer tenures, between 5 and 30 years. Their fixed income stream makes them popular among investors seeking certain returns.

How Covered Bonds Can Improve Your Investment Portfolio?

Covered bonds could enhance one's investment portfolio in the following ways:

1. Benefits Of Diversification

Investing in covered bonds, along with other more risky assets like equities, reduces overall risk across the whole portfolio. Stocks or mutual funds have a higher volatility risk. Covered bonds provide constant cash flow from investments irrespective of whether market changes affect other investments.

2. Suitable For Conservative Investors

They serve conservative investors as covered bonds are low-risk-dedicated fixed-income instruments. Investors can secure their capital and generative returns at intervals because they are highly rated and have a lower probability of default than corporate bonds. It suits investors who require stability rather than aggressive growth. Those who invest mostly in FDs often show interest in covered bonds. 

3. Hedge Against Economic Downturn

During an economic recession, stocks or company bonds carry more risk as they tend to drop in value in response to market movements. However, covered bonds are now quite resilient with the dual recourse shield. This is why they remain a hedge against financial crises.

Conclusion

For more secure investments yielding consistent returns, covered bonds would be a viable option. They have the underlying collateral support and tight regulations, offering reliability in turbulent markets. Covered bonds offer reduced risks, return security and stability. So, they are good for diversification. Log-in to Grip Invest to set your investment goals and discover how covered bonds fit into your long-term strategy.

Frequently Asked Questions On Covered Bonds

1. How are covered bonds different from secured bonds?

Secured bonds have a collateral asset like real estate, inventory, or equipment of the bond issuer. Covered bonds have an underlying pool of assets, and investors have recourse to both the issuing bank and the underlying assets.

2. Who issues covered bonds?

Covered bonds may be issued by banks, housing finance companies (HFCs), or non-banking financial companies (NBFCs).

3. Do covered bonds carry prepayment risk?

Yes, but it is minimal. In case borrowers make prepayments, issuers balance prepaid loans with fresh assets to ensure coverage. Relative to ordinary bonds, covered bonds insulate investors against prepayment disruption.

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