What is a Covered Bond?
Covered Bonds (CB) are hybrid debt instruments that has an asset pool backing the interest and principal repayments. It closely mirrors asset-backed securities except that in case of CBs, the issuer has to replace the asset when in default or when it matures on the balance sheet. The instrument tenor ranges between1-30 years with main investors in CBs being Central Banks, Pension Funds, Bank treasuries, Asset Managers and Insurance Companies.
Genesis of CB
Let’s go back in time how such instruments were first placed. During the debt crisis in 1700s, mainly in Prussia and Denmark, CBs were used to finance big public projects. In one such instance, The Great Fire of Copenhagen burnt a quarter of an entire city down. Thus came the need for a massive development of buildings in a short period of time leading the organised credit market coming up with a product like CB. Ever since, such instruments have been popular in Europe (Denmark, Germany, France, Spain and Sweden) comprising ~60% of CBs issued worldwide which stands at USD 3trillion (EUR 2.5trillion) at end-2019.
Being a refinancing tool in the western countries for over two centuries, CBs garnered attention after the global crisis in 2008, particularly after the mortgage-backed securities debacle. Its features like security and full recourse made it a safer bet for investors; mortgages and public sector debt are the pool of assets that typically back a CB.
Relevancy of CB to the Indian market?
CB debuted in the Indian debt market with the an issue size of INR 25 crores by Kogta Financial India Ltd in Jan 2019. It was followed by Muthoot Finance with an issue size of INR125 crores. Following the credit crisis, CB issuances became a preferred choice to raise funds for NBFCs that were paying significantly more to roll over short-term debt. As a result, their borrowing mix has changed strengthening balance sheet liquidity. Furthermore, CBs could also benefit the housing market in improving the liquidity and funding cost of such financial institutions; home mortgages could be used as an asset pool to cover the loan and interest payments of the investors and also provide adequate collaterals over a period of time.
For strategic long-term retail investors, the debt market has limited offerings in the form of debt mutual funds, fixed deposits and a selected few bonds. As it is, India’s bond market is not deep enough with low levels of retail investor participation and lack of a secondary market to trade. Given such a landscape, the addition of CB would add some cheer to the pack of choices for the investors who look up to debt investments.
From a risk-reward perspective, the table below seem to appeal to the larger section of investors, mainly retail.
Looking at the yearly returns, fixed deposits (4-5% pa in 2021 vs. 8.5% in 2014) has clearly lost its sheen as the goto investment for debt investors long back. Still, for lack of awareness, most of the investors are migrating to the debt mutual fund (DMF) and/or PSU bonds, rather slowly.
In this situation, CBs can be a well-suited investment option for the debt investors, especially given the higher returns vis-a-vis other choices. While this was only open to HNIs before, the flood gates have now been open to cater to a wider set of audience.
Some of the advantages for the retail investors in investing in CBs are:
- Minimum investment of INR 10,000
- Cash-flows rely on originator for periodic interest payments to investors
- Over-collateralisation of asset pool (~125%) in case of default or maturity
- Rated higher than that of issuer rating considering better safety
- Seniority to the investors in case of a recourse post default
- Very low (<3-5%) probability of default
So far, 4 issues have been open to the retail investors in the Indian Debt market:
To learn more about the issue details, please visit https://www.wintwealth.com/
Clearly, investing in CBs is an apt choice for low-moderate risk investors who shun away from equity MFs and stocks but require a rate of return in the high single digits to low double digits. Thus, CBs have a great potential to build trust and confidence in investors over the years to come and to create a thriving debt market.
References: Wikipedia, S&P Global Report on Covered Bonds, vinodkothari.com, wintwealth.com