Stronger bonds

Covered bonds are bonds usually issued by specially authorised restricted activity bank issuers, which are generally secured by means of a statutory preference over a ringfenced pool of assets. The asset pool may be comprised, in the main, of mortgages (residential or commercial) or public sector credits (ie loans to sovereigns, municipal authorities etc).

The longest established and best-known covered bonds are German pfandbriefe, which have been issued by German institutions for more than 200 years. Over the centuries, a number of other European jurisdictions, including Austria, Denmark, France, Luxembourg and Spain, have created legal structures for the issuance of covered bonds, and the covered bond market is now the largest European bond market outside government securities. While Ireland joined this list very recently, interest in covered bonds continues to grow rapidly, with a number of other jurisdictions introducing covered bond codes or examining the possibility of doing so.

Unlike securitised debt, which is created and secured by means of an appropriate network of contractual relationships, the legal framework for covered bonds is typically contained in legislation. The UK covered bond launched by HBOS in 2003 without the benefit of specific UK legislation relies on the UK’s strongly pro-secured creditor legal regime and is unlikely to be replicated elsewhere. It is generally a combination of a legislative foundation (which eliminates a certain amount of legal risk inherent in other secured financing structures), the restricted activity bank status of the issuers, the bankruptcy isolated status of the asset pools on which the bonds are secured, and the low-risk nature of those assets that allows covered bonds to achieve high credit ratings, thus making them a valuable funding tool for issuers.

While covered bonds have been a feature of the European capital markets for well over 200 years, it is only recently that they ceased to be purely domestic instruments and found a wider global investor base. The emergence of a number of jumbo pfandbriefe issues in the latter half of the 1990s showed that there was a global market for highly rated and liquid covered bonds. It is in this context that the introduction of Irish covered bonds (known as asset-covered securities (ACS)) should be viewed.

The legislative framework governing the issue of ACS and creating the bondholder’s statutory preference over the ringfenced asset pools maintained by issuers is contained in the Asset Covered Securities Act 2001 (the ACS Act). 2003 saw the first operation of the ACS Act through debut issues of ACS by two public credit sector issuers, Depfa ACS Bank and WestLB Covered Bond Bank. By the end of April 2004, Depfa had approximately €14.5bn (£9.68bn) of ACS in issue, while WestLB Covered Bond Bank had €3.5bn (£2.34bn) of securities outstanding.

The high value of issuance last year represents a resounding success for the Irish product in the international capital markets, with each issue having been well received by the investor community and having achieved highly satisfactory pricing. All issues of ACS by both Depfa and WestLB Covered Bond Bank have been rated AAA.

One of the principal reasons for the initial success of ACS lies in the strength of the governing legislation. Ireland is the first English-speaking common law jurisdiction to enact legislation for the issue of covered bonds. The product of cooperation between the Irish banking industry and the Irish government, the legislation is seen as being at the cutting-edge of European covered bond legislation, as it provides: protection of investors on the insolvency of an issuer; measures to address potential asset and liability mismatches within the issuer; legislative enforcement of overcollateralisation; a strong role for an independent asset monitor; a statutory back-up servicing feature; and a wide supervisory function for the banking regulator.

Another important advantage of the Irish legislation is its in-built flexibility. Many of the detailed provisions of the ACS Act can be adjusted by means of secondary legislation – usually by orders or regulations passed either by the Minister for Finance or the Irish Financial Services Regulatory Authority (IFSRA). This means that the ACS Act can, within limits, provide an organic framework for the issue of Irish covered bonds, which can be adapted swiftly to meet the expectations of a developing market. For these reasons, only three years after its enactment, the ACS Act is now seen by many in the market as the benchmark for European covered bond legislation.

The two issuers of ACS to date have issued public credit-covered securities. No institution has yet been registered by the IFSRA as an issuer of mortgage-covered securities (ie ACS secured on a pool of mortgages) and, accordingly, no issue of mortgage-covered securities under the ACS Act has occurred. However, at least one Irish financial institution –the Bank of Ireland – has announced publicly its intention of establishing a programme for the issuance of mortgage covered bonds, which were initially secured on Irish residential mortgages, but later incorporated UK residential mortgages too. The Bank of Ireland’s proposal is to issue €10bn (£6.68bn) of ACS over the next four or five years. Other financial institutions are also believed to be exploring the possibility.

Successfully including UK (or other non-Irish) mortgages in a cover assets pool maintained by an Irish incorporated and regulated issuer of ACS presents a number of interesting legal challenges. However, assuming that these can be overcome, the potential of ACS as a cross-border financing tool for international financial institutions appears to be enormous.

Ireland covered bonds: Q&A
Why are asset-covered securities in the news?

Bank of Ireland has announced its intention to establish the first asset-covered securities programme to be secured on a residential loan book. In the past 12 months, over €14.5bn (£9.68bn) of asset-covered securities secured on Irish government loans have been issued by two Irish banks: WestLB Covered Bond Bank and Depfa ACS Bank. Asset-covered securities are one of the most important developments in the Irish capital markets in recent years.

What are asset-covered securities?

Asset-covered securities are Irish covered bonds. Covered bonds are European-style bonds that are secured over residential loans or government loans and which are issued by special banks.

Who can issue asset-covered securities?

Only special banks authorised by the Irish Financial Services Regulatory Authority (IFSRA), which limits their activities to residential lending or government lending, can issue asset-covered securities.

How are issuers and issues of asset-covered securities regulated?

They are regulated under a special piece of legislation, the Asset Covered Securities Act 2001. This makes asset-covered securities different to other bonds. The issuers are also regulated under general banking legislation. The Irish banking regulator, the IFSRA, supervises those banks that issue asset-covered securities. The 2001 act is regarded as state-of-the-art in covered bond legislation by the international capital markets.

What type of investments are covered bonds/asset-covered securities?

They generally carry an AAA rating, which is the highest rating given by rating agencies. This means that they are regarded as the safest type of investment. They are regarded by investors as an alternative to government bonds.

Are issues of covered bonds/asset-covered securities large or small?

Public issues of asset-covered securities are made in large amounts, with a minimum total amount of €1bn (£667.7m), but often in much larger amounts. These are known as ‘jumbo’ issues. Issues smaller than e1bn would often be private issues to a limited number of investors.

Fergus Gillen is a partner-elect in the banking and financial services group at McCann FitzGerald in Dublin