“The New Bond In Town”- Demystifying Covered Bonds

The social media is buzzing about a relatively new fixed income instrument named “COVERED BOND”. The promised returns are attractive in the current yield starved environment. However, it’s a relatively complex structure for an average investor to grasp.

“Covered bonds” however, are of European origins, with a history of around 250 years. They are structurally superior to asset backed securities because of its ability to offer “bankruptcy protection”. The “dual cover” and the “dynamic pool” makes it safer than the prevalent asset backed securities. The security even gets a superior rating as compared to the parent issuer.

However, It’s a relatively newer phenomenon in our country. The hype on social media about “covered bonds” has suddenly surged, with many personal finance influencers on YouTube taking this story out, to the masses. The narrative on this is largely being pushed by a leading discount-broker funded start-up. Prima facie the concept is encouraging and promises  superior return to yield starved (retail and HNI) investors. But the composition of these “structured finance” instruments is rather complex. Yet it is being marketed to the masses with ticket sizes as low as ~Rs.10000. The issuers are generally small NBFCs, Muthoot being the only exception so far. At times, the rating agencies involved are also not top tier. Which is perhaps the reason, why an investors should exercise caution before investing in these instruments. 

The intermediaries may often use a trust structure and may even package the instrument with an MLD wrapper for tax-efficiency and subsequently down-sell it to the investors. A fairly complex structure in comparison to the rather simplistic pitch to investors. 

Therefore, one needs to be cautious about the due diligence undertaken in evaluating the nature of the securities pool, the size of the cover pool in comparison to the issue size, the covenants in place, the rating agency involved etc.

All in all, the informed investors will benefit from an asset class like this. The instrument will also makes it easier for smaller NBFCs, to raise funds at lower cost. 

However, the agencies involved in the securitisation and down-selling of the product to investors will play a significant role in identifying the right pool of assets, conducting regular due-diligence of the “dynamic pool of assets” and in communicating the risks adequately to the investor. 

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