Covered bonds are debt instruments issued by a credit institution backed by a cover pool of collaterals. Covered bonds are in essence “dual recourse” bonds, because they enable investors to have a claim against the issuer but also, in case of default, against the cover pool. The attractive feature for investors is the lower risk profile with a relatively high return as compared to other debt instruments. The issuance of covered bonds is a low cost source of funding for banks, but also a diversification mechanism that facilitates their asset-liability management, and often covered bonds allow for higher credit ratings due to their double recourse nature.Covered bonds are one of the largest segments of the European bond market, presenting, at the end of 2007, an outstanding volume of 2,050,895 euros (EUR)  from the EU member states 1. For this reason, during the expansion of the covered bond market, a complex regulatory framework that includes national legislations and European directives has been developed. The European legislation on covered bonds is based on two directives. Firstly, the 85/611/EEC Directive on Undertakings for Collective Investments in Transferable Securities (UCITS) defines covered bonds as bonds issued by a credit institution subject to special prudential public supervision. To protect investors, covered bond issuance rules are included in a specific legal framework, the set of eligible assets in the cover pool must be assessed by law, and in the event of an issuer’s failure bondholders must have priority claim against the cover asset pool. The Directives also set out the limits on the concentration of investments in securities made by investment funds in the covered bonds of a single issuer. These limits are higher than those provided for other kind of debt instruments, according to the compliance with the specific requirements set out by article 22(4) of the Directive. Secondly, the Directive 2006/48/EC and 2006/49/EC, known as the Capital Requirement Directive (CRD), introduce a credit risk weight assigned to covered bonds.

1Source European Central Bank Report, Covered Bonds in the EU Financial system, December 2008 

European Central Bank Report, Covered Bonds in the EU Financial system, December 2008.

Editor: Bianca GIANNINI