Covered bonds FAQs

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Covered bonds are debt securities, generally issued by banks, under which the bond holder has both an unsecured claim over the issuing bank and holds a secured interest over a specific pool of assets set aside by the issuing bank (the ‘cover pool’).

Covered bonds can be distinguished from senior unsecured debt instruments issued by banks, where the bond holder is simply an unsecured creditor of the bank, and also from asset-backed securities, where the bond holder holds a secured interest in the cover pool but has no claim on the issuing bank.

Covered bonds are generally issued by bank or bank-like institutions. The international covered bond market is substantial, with the European Central Bank reporting that the volume of covered bonds outstanding at the end of 2008 was €2.4 trillion.[1] Total issuance by New Zealand banks as at March 2013 was $11 billion.

[1] Source: European Central Bank, “Financial integration in Europe April 2010

In Europe, the largest investors in covered bonds have traditionally been insurers, investment fund managers, banks, central banks and asset management funds. New Zealand registered banks issuing an off-shore covered bond would expect to access the same pool of investors. The issuance of New Zealand dollar-denominated bonds would be attractive to New Zealand fund managers and large insurers.

As a secured debt instrument, covered bonds have proved to be a relatively stable source of funding over the recent period of volatility in financial markets. In particular, covered bond markets have remained accessible when unsecured wholesale markets have not. In this way, a bank’s ability to issue covered bonds should reduce the possibility of it experiencing liquidity problems.

Covered bonds will also be a valuable additional source of long-term funding as banks seek to lengthen the maturity profile of their funding structures in line with the core funding ratio in the Reserve Bank’s liquidity requirements.

Covered bonds can also offer potential pricing benefits for banks, by enabling highly rated banks to access cheaper funding.

Legislative changes were made in 2013 to address legal uncertainty associated with covered bonds issued by New Zealand registered banks. The Reserve Bank of New Zealand (Covered Bonds) Amendment Act 2013 gives covered bond holders greater certainty regarding enforcement of their security interest over cover pool assets should an issuing bank fail. The legislation also provides greater transparency of covered bond issuance by New Zealand registered banks and provides for minimum standards of monitoring.

Legislative frameworks for the issuance of covered bonds are commonplace internationally. They are also a prerequisite for investment for some covered bond investors.

Under the legislation, banks cannot issue covered bonds other than under a covered bond programme registered with the Reserve Bank, and they must notify all issuance under that programme to the Bank. A programme will only be able to be registered if it meets certain requirements, including that:

  • the cover pool assets are held by a special purpose vehicle that is a New Zealand incorporated company;
  • a cover pool monitor has been appointed to monitor the programme; and
  • the programme documentation meets certain requirements, such as providing a solvency test for the special purpose vehicle.

The legislation clarifies the legal status of cover pools under registered covered bond programmes if the issuing bank fails. The legislation ensures that the covered bond special purpose vehicle remains outside the failure resolution process of the issuing bank, should the issuing bank be placed into statutory management or liquidation.

The legislation applies to New Zealand registered banks. However, the legislation may be extended by regulation to other entities or classes of entities.

In 2011, Australia passed legislation to allow the issuance of covered bonds by Authorised Deposit-taking Institutions -‘ADIs’ which include banks, credit unions and building societies. In general, the New Zealand requirements align well with Australia’s. For example, both require that cover pool assets be held by a special purpose vehicle and that a cover pool monitor be appointed. The Australian legislation also provides that the cover pool special purpose vehicle will remain outside of any ADI failure resolution process.

One of the major differences between the regimes is the registration of covered bond programmes under the New Zealand regime, which is not a feature of the Australian regime. The Reserve Bank considers that registration is important to ensure that the requirements imposed on covered bond programmes are met. A public register of covered bonds also provides greater transparency about the level of covered bond issuance by New Zealand banks. Registration is consistent with other covered bond frameworks, such as in the United Kingdom.

The level and form of supervision of covered bond programmes differs between jurisdictions. It is common for jurisdictions to require the appointment of a cover pool monitor to supervise the cover pool. However, in some jurisdictions, such as the United Kingdom, the regulator also undertakes extensive supervision.

Under the Reserve Bank of New Zealand (Covered Bonds) Amendment Act 2013, banks cannot issue covered bonds other than under covered bond programmes registered with the Reserve Bank. The Reserve Bank must satisfy itself that the banks’ programmes meet the requirements of the legislation, which includes a requirement that the issuer appoints an independent cover pool monitor for its covered bond programme. The functions of the cover pool monitor are prescribed in the legislation.

The obligations on the issuing banks under the legislation apply both at the time of registration and at all times that covered bonds are issued under the programme. The Reserve Bank monitors banks’ compliance with these obligations, as well as their compliance with the limit the Reserve Bank has placed on banks’ covered bond issuance, as part of its monitoring of registered banks’ compliance with their conditions of registration.

The Reserve Bank considers that the assets eligible to be included in the cover pool do not need to be prescribed by legislation because banks specify asset eligibility in programme documentation. Legislative restrictions on cover pool assets may unnecessarily restrict an issuer’s ability to develop covered bond programmes. However, to allow for future market developments, the legislation provides that the Reserve Bank may register covered bond programmes under class designations based on the types of assets in the cover pool. The issuing bank will be required to ensure that only the assets allowed in the asset class designation are included in the relevant cover pool.

The cover pool assets must meet certain criteria for the covered bond to be eligible for inclusion within the Reserve Bank’s domestic markets operations.

The issuing bank is generally required, under its programme documentation, to maintain the quality of the cover pool. As a result, any non-performing loans, or loans that no longer meet the requirements of the cover pool, will have to be replaced by new loans from the issuing bank’s book. Given this practice may reduce the quality of the assets available to meet the claims of unsecured creditors, should the issuing bank later fail, the Reserve Bank has set a limit on the level of a bank’s assets that may be encumbered in favour of covered bonds.

Covered bonds give covered bond investors priority claim over a portion of the issuing bank’s assets. In the event of the failure of an issuing bank, this will reduce the value of the assets available to meet the claims of other creditors and depositors and, as such, may increase any losses incurred by them. However, covered bond issuance may also benefit depositors in that, at low levels of issuance, increasing funding diversity (by developing a covered bond programme) can potentially reduce the probability of a failure occurring.

In deciding to allow covered bond issuance, the Reserve Bank considered the benefits of reducing the probability that an issuing bank may fail, and the cost of potentially increasing the losses that may be suffered by the other creditors and depositors in the event of failure. These considerations have been balanced by the imposition of a limit on covered bond issuance. This limit is 10 percent of the total assets of an issuing bank, calculated on the value of assets encumbered for the benefit of covered bond holders.

Depositors may also benefit from banks’ covered bond issuance, as it gives banks access to cheaper funding. This may translate into cheaper loans for New Zealand borrowers or higher interest payments for New Zealand savers, depending on the competitive forces in the market. In principle, accessing cheaper funding should allow banks to compete more aggressively for retail customers.

The Reserve Bank considers that issuance of covered bonds by New Zealand banks supports financial stability as covered bonds allow banks to diversify their funding by providing access to new investors and to a funding market that has been very resilient, even during the global financial crisis. The Reserve Bank imposes a limit on issuance of covered bonds, which balances the benefits of covered bond issuance against the impact on depositors and other unsecured creditors.
If a mortgage granted by an issuing bank is placed into the cover pool, this will have no impact on the mortgage holder while the bank remains solvent.

The Reserve Bank accepts covered bonds as collateral under its domestic market operations, subject to certain requirements being met, including the bond being New Zealand dollar-denominated and meeting a number of criteria such as minimum credit ratings and cover pool asset quality requirements. These requirements may change from time to time.

More information on covered bonds in New Zealand is available in this Bulletin article Discovering covered bonds – the market, the challenges, and the Reserve Bank’s response.