Covered bonds take root in UK treasury portfolios

As discussions in Europe continue on how to treat covered bonds in banks’ liquidity buffers, the instrument is emerging as an increasingly popular form of investment for councils.
Denmark, which is home to the world’s biggest covered bond market per capita, seems to be on the verge of winning concessions from the European Commission, which is attempting to cap the use of the securities in the buffers to 40 per cent.
According to David Green, client director at local government treasury adviser Arlingclose, more than 20 of his clients were examining the instrument with three having already taken the plunge.
The bonds return lower yields than ordinary bonds but are backed by assets which means they are less vulnerable to bail-in risk.
Green said: “There is definitely more interest in covered bonds starting to emerge. It is a reaction to bail-in, as they are unlikely to be liable to any haircut following financial crisis.
“The downside is the rate they offer, but if you get 2 per cent for five years, risk free, that is more attractive to some than half a per cent for six months and then hoping that the rate will go up.”
Lorne Williams is treasurer at Coventry Building Society, which regularly issues covered bonds to the wholesale market, through which councils then access them.
Williams explained that covered bonds were similar to normal bonds, but if there was a default, then the trustee administering the issuer would have access to ring-fenced assets – mortgage books in Coventry’s case, but often public sector debt.
He said: “The amount that is ring-fenced is bigger than the amount issued – it is 28 per cent higher in our case, but goes above that for lower quality mortgages. This buffer gives confidence to rating agencies that the bond is properly covered.”
Covered bonds are a relatively new addition to the UK’s investment landscape, but have been used in Europe for 250 years.
The UK covered bond market was established in July 2003 under a general law framework. In March 2008 the Treasury introduced the Regulated Covered Bond Regulations 2008, which provide a dedicated legal framework for the UK market.
Germany currently has the largest and most diverse investor base in the product within Europe.