What Can the UK Market Learn from the Nordic Covered Bond Market? – Insights from Our Nordic Neighbours
Covered bonds, a growing interest in the UK markets, bear a resemblance to their well-established counterparts in Nordic countries. As the UK explores this financial instrument, there are valuable lessons to be gleaned from the Nordic covered bond market. This article delves into the mechanics of covered bonds, explores the reasons behind their popularity in Nordic nations, and highlights the key takeaways that UK banks can consider for their covered bond initiatives.
What are covered bonds?
Covered bonds are a type of debt security that is issued by banks, as a way to raise funds for lending and other financial activities. Covered bonds are debt instruments secured by a cover pool of mortgage loans. A covered bond is a package of loans that were issued by banks and then sold to a financial institution for resale. The individual loans that make up the package remain on the books of the banks that issued them, serving as a collateral pool and conveying an additional layer of security for holders of the covered bonds. These bonds are unique in that they are backed by a specific pool of high-quality assets, known as a “cover pool,” which provides an added layer of security for bondholders.
Here’s how covered bonds work:
- Issuer: A bank decides to issue covered bonds to raise capital. The bonds are typically issued by a separate legal entity, often called a “special purpose vehicle” (SPV), which is established solely for the purpose of issuing covered bonds.
- Cover Pool: The issuing bank creates a cover pool, which is a specific group of assets that serves as collateral for the covered bonds. These assets are typically high-quality and can include residential or commercial mortgage loans, public sector loans, or other similar assets. The cover pool is designed to provide a secure and stable source of repayment for the bonds.
- Ring-Fencing: The assets in the cover pool are legally separated from the issuer’s other assets. This separation, known as “ring-fencing,” helps protect bondholders by ensuring that the cover pool assets are only used to repay the covered bonds and are not subject to the issuer’s other financial obligations.
- Dual Recourse: Covered bonds offer a form of dual recourse. This means that bondholders have two potential sources of repayment: they can rely on the cash flows generated by the cover pool assets, and they also have a claim against the issuing bank’s general assets. In the event of default, bondholders have a priority claim on the cover pool assets.
- Issuer’s Obligations: The issuing bank remains responsible for servicing the assets in the cover pool and maintaining the required quality of assets. If the value of the assets in the cover pool falls below a certain level, the issuer may need to replace or replenish the assets to maintain the required collateral coverage.
- Interest Payments and Maturity: Just like other bonds, covered bonds pay regular interest to bondholders. The interest rate is determined at the time of issuance. Covered bonds also have a maturity date, at which point the issuer is obligated to repay the principal amount to bondholders.
- Regulation and Supervision: Covered bonds are subject to regulatory and supervisory frameworks that vary by jurisdiction. These regulations often include requirements related to the quality and diversification of the cover pool assets, the level of overcollateralization (the ratio of cover pool assets to outstanding bonds), and disclosure to investors.
Covered bonds are considered relatively safe investments due to their dual recourse structure and the underlying collateral. They are often seen as an attractive option for investors seeking a balance between safety and yield. However, the specific features and regulations surrounding covered bonds can vary significantly depending on the country and jurisdiction in which they are issued.
Why Are Covered Bonds Popular in Nordic Countries?
The Nordic covered bond market has flourished for various reasons, intertwining historical legacy, regulatory strength, and economic stability. The Nordic success story can be attributed to:
- Historical Development: With roots dating back to the 18th century, the Nordic covered bond market’s early adoption and evolution in Sweden and Denmark laid the groundwork for a robust and trustworthy market.
- Stable Banking Systems: The reputation of stable and resilient banking systems in Nordic countries provides a solid foundation for covered bond issuance, instilling investor confidence.
- Strong Legal Framework: The comprehensive and investor-friendly legal frameworks governing covered bonds enhance transparency, protection, and attractiveness for investors.
- Government Support: Governments in Nordic nations acknowledge the role of covered bonds in fostering housing and economic growth, potentially offering regulatory or governmental backing.
- Quality and Safety: The appeal of secure investments aligns with investor preferences, and the dual recourse feature adds a layer of security for bondholders.
- Diversification and Low Default Rates: Nordic countries’ emphasis on diversified cover pool assets and historically low default rates contribute to the stability and creditworthiness of covered bonds.
- Transparency and Education: Transparent reporting practices and investor education efforts contribute to a better understanding and appreciation of covered bonds.
- Investor Familiarity: A rich history of covered bonds has cultivated familiarity among investors, driving demand and active participation in the market.
Applying Nordic Lessons to the UK
UK banks can draw valuable insights from the Nordic covered bond market to refine their own covered bond issuance strategies. Key areas to focus on include:
- Asset Quality and Risk Management: Prioritizing high-quality cover pool assets and conducting rigorous risk assessments.
- Transparency and Reporting: Enhancing transparency through standardized and detailed reporting practices.
- Innovation and Diversification: Exploring innovative approaches to diversify cover pool assets and align with specific economic or sustainability goals.
- Collaboration with Regulators: Proactively engaging with regulatory authorities to establish best practices and ensure compliance.
- Stress Testing and Resilience: Incorporating regular stress testing to evaluate the robustness of covered bond programs.
- Sustainable Finance Integration: Aligning covered bond programs with sustainable finance principles to meet the growing demand for responsible investments.
- Risk Mitigation and Contingency Planning: Developing strategies to navigate various market conditions and maintain covered bond issuance capabilities.
As the UK navigates its covered bond journey, the Nordic covered bond market serves as an inspiring model. By embracing the Nordic lessons of asset quality, transparency, innovation, and resilience, UK banks can fortify their covered bond programs, engage investors effectively, and contribute to the emergence of a strong and sustainable covered bond market in the UK. While challenges and uncertainties persist, the foundation laid by the Nordic experience offers a roadmap for success and growth.
MORS Supports Covered Bond Pools. Are you able to take advantage of this relatively low-cost funding source? Contact us to learn more.
MORS Covered Bond Pool is an add-on module for other MORS modules. All components of the Pool are included: individual loan assets, issued bonds, substitute collateral and hedges. Easy to create a pool of Assets and to link it with certain Liability side funding. Mortgage Banking handling and reporting directly from the system. Fulfilling the regulatory requirements.