Co-published Covered bonds guide: ICMA Q&A


Covered bonds’ next generation


RBS managing director, International Capital Market Association (ICMA) board member, and covered bond specialist Tim Skeet discusses recent market developments and the asset class’s future


What factors should an investor consider when choosing between Residential Mortgage-Backed Securities (RMBS) and covered bonds? Covered bonds share certain fundamental characteristics with RMBS – the bankruptcy remoteness, and the ring fenced assets, for example. RMBS are typically a risk product. The


robustness of the structure and the creditworthiness of the underlying assets are key. And as such deals typically have amortising structures, a lot depends on individual risk and cashflow appetite. Investors that want to buy that sort of


instrument must look to where the product sits in the credit structure of a particular transaction, and understand the degree of risk within that structure and consider maturity risk. But above all they need to form their own view on the creditworthiness of the underlying assets because that’s what’s going to get them repaid. In contrast, covered bonds are dual


recourse; the issuer is the primary source of repayment, not the underlying assets. The product is therefore relatively credit-lite as investors need to take a view first on the issuer, and then on the underlying collateral as back-up. The note itself is equivalent to the ‘super senior’ class of RMBS in many respects, but without the option to buy more subordinated pieces. Covered bonds also have bullet maturities, which means the cash flows are


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much more predictable. That said there’s quite a lot less spread on a covered bond compared to RMBS. The level of legal support available for


the two products is also crucially different. For RMBS, investor rights are typically contractual. In contrast, covered bonds are defined by law. Investors can thereby take comfort in the statutory protection offered by the instrument.


What are your views on the European Covered Bond Council (ECBC) covered bond label and what benefits do you think it will offer? The labelling initiative pioneered by the ECBC, is based on a simple philosophy – to clearly define what is, and what is not, a covered bond. Helpfully it also specifies minimum levels of disclosure as well as characteristics, such as the underlying asset classes. Labelling will hopefully lead to a discernible price advantage in future. Defining the product is an ongoing challenge for the market. Such a definition needs to encompass all the variations in jurisdictional practices and market idiosyncrasies, while still preserving the traditional covered bond concept as defined under European practice. Under the Anglo-Saxon precedent, it’s possible to use the term ‘covered bond’ for a range of instruments, because it’s not trademarked in any way. Linguists note that the term ‘covered bond’ is a far more generic term than the closely defined


The ECBC label initiative is a sensible and logical precaution to prevent future reputation risk or abuse of the structure


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Debate will rage around the use of the expression ‘covered bond’


‘pfandbrief ’ and is therefore in reality a poor translation of the original German concept. The industry therefore rightly wants to


find a way of ensuring investors know that if they buy a covered bond, they’re buying an instrument that’s extraordinarily safe. The ECBC’s project seems to have been


well accepted. Everybody realises why they need to do it – it’s a sensible and logical precaution to prevent future reputation risk or abuse of the structure. After all, it’s concerning that reputational damage could be caused to covered bonds in the event of a future crisis, through irresponsible repackaging of intrinsically-risky assets masquerading as riskless or low-risk covered bonds.


Issuers in some jurisdictions are looking at new cover pool asset classes such as SME loans. What are your thoughts on this development? Do you think other asset classes could be eligible for inclusion in the cover pool in future? This goes to the heart of what the labelling project is all about. Prior to March 2008, contractual


covered bonds were issued in the UK. The move prompted severe criticism, primarily from the German market – the traditional home of covered bonds and the pfandbrief. Critics believed these contractual


covered bonds did not conform to the norms as required by the market, or offer as much investor protection, and called for the introduction of a specific UK covered bonds law. The UK subsequently introduced the Regulated Covered Bond Regulations in 2008. Fast-forward a few years, and we now


have a new type of covered bond – the SME-backed covered bond, in which the


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