Covered Bonds - a risky bet

Covered Bonds, at the face of it, seems to mitigate significant risk since they have an additional collateral cover to account for defaults. But the devil is always in the details.

What are Covered Bonds?

Covered bond is an instrument via which the investors lend money to an entity (corporate or government) and earn income from this investment. Though this is also true for any other government or corporate bond, what separates covered bonds from regular bonds is that covered bonds are secure bonds that are collateralized against a pool of assets assuring the investor recovery of the invested funds, in case there is a failure on part of the borrower. 

So, to summarize, covered bonds are debt securities issued by a bank or a Non-Banking Financial Company (NBFC) which are collateralized against a pool of assets. In case of failure of payment from the issuer, the amount can be recovered from the pool of assets.

How Covered Bonds came into existence?

In Europe, covered bond has existed for around two centuries now. These were first issued in the Prussian Empire to aid in the funding of the seven years’ war. Covered bonds became even more popular during the European debt crisis since at the time investors were not willing to invest in 'unsecured' bonds which are typically issued by the banks. Covered bond had a higher credit rating (because of the collateral), and hence, the investors would be lured to invest in them.

Today, covered bonds are quite popular in Europe, Japan, South Korea, New Zealand, Australia, and there is a growing potential for them in emerging economies of Asia and Latin America.

Structure of Covered Bonds

- Bank or NBFC issues bonds to the investors.
- As a recourse (safety measure), a cover pool of secured loans is also taken. The cover pool of secured loans consists of housing loan, vehicle loan, gold loan etc. 
- The bank or NBFC pays the principal + interest to the investors at the end of maturity of the bond.
- If the bank or NBFC fails to make the payment, the amount can be recovered from the cover pool.

Covered Bonds Vs secured Corporate Bonds.

Yes, there also exists something like 'Secured' Corporate Bonds. Secured corporate bonds provide recourse against the issuer. This means that in case of a default by the issuer (bank or NBFC or corporate), the investor has the legal right to challenge the issuer in the court of law and get his or her due.
However, remember that such a recourse ceases to exist if the issuer itself declares bankruptcy.
That is where covered bonds pitch in. Covered bonds are different form these secured bonds.

Covered bonds provide a dual recourse – that is, first recourse against the issuer, and then a bankruptcy-protected recourse against the assets of the issuer (cover pool) too. So, even if the issuer goes bankrupt, there is a covering of assets (loan book of the issuer). Generally, due to the cover provided, covered bonds are expected to provide a credit rating upliftment, over and above the credit rating of the issuer.

For instance, a pool of gold loans may be used to back a covered bond. The income from these loans will be used to pay the coupon (fixed interest) to the investor. In addition, the bond will be backed by collateral in the form of gold, to cover investors in the case of a default. This gives double recourse to investors. The dual recourse benefit is the “most attractive” feature of these bonds.

Covered Bonds Vs Asset Backed Securities (ABS)

Asset Back Securities also back up the security (like a bond) with an asset, or a set of assets. But once the mapping of a security with a set of assets are done, the mapping does not change through the life of the bond. There can be many situations where the assets backing the security may default by themselves. e.g. if a corporate bond is backed up with a vehicle loan given to some 3rd party, and if the 3rd party defaults on the vehicle loan, then the backing has actually now become meaningless for an investor.

The key difference between Covered Bond and ABS is that issuer of ABS is not required to replace assets that default or mature on the balance sheet, which is required in the case of covered bonds.

Demand for Covered Bonds

The demand for Covered Bonds has definitely picked up in India. Between April 2020 and March 2021, non-bank lenders raised Rs 2,218 crore, compared to Rs 400 crore raised in the previous fiscal, and a meagre Rs. 65 crore a fiscal before that. And about 75% of such issuances have come from entities with a credit rating of A and above.

Rating 

Due to the benefit of security pool, covered bonds are usually rated higher than their issuer entities, in turn, reducing the cost of borrowing for issuers. This benefit could be 50-150 basis points below the cost of borrowing via other means.

Two common structures of Covered Bonds

Covered bonds may be structured in multiple ways. Those which are structured as MLDs (Market Linked Debentures) offer better net of tax returns compared to NCDs (Non Convertible Debentures) or other debt instruments that are available, besides offering relatively higher yields. This, as MLDs, usually issued for a period of 13-60 months, are presently taxed at 10% plus surcharge. NCDs attract a 20% long-term capital gains tax applicable when sold after a year or before the maturity date.

How can Bonds be ‘market-linked’?

Covered bonds are debt instruments with fixed coupon rate. But then why are they termed as 'marked linked'? Don't get confused. We have a habit of making simple things, complex. That’s some product innovation for you from those offering it, to make the product more tax efficient, and also complex. 

In one of the products, for instance, the bond’s returns are linked to a reference index – the Sensex. If the Sensex drops to 10,127 or below, you will only get your principal back. But if it stays above this (unrealistically low) level, you will get your principal and stated IRR. Now, this ‘linking’ to a benchmark makes this a market-linked debenture. This is done to improve your tax status. We know that if a financial product is linked to equity market, it offers significant tax advantages to the investor.

How are covered bonds taxed?

In a normal covered bond or debenture, your interest income is taxed at your slab rate. But in a covered bond with a market linked debenture structure, you will enjoy 10% tax if you hold for over 12 months (it is treated as a capital gain). This makes the tax significantly lower than regular tax on interest income. Interest is taxed at your slab rate for holdings less than 12 months. Therefore, you will see that most covered bonds come with call options that go beyond 12 months.

Are these covered bonds/market-linked debentures listed?

The information memorandum of the bond will mention whether these bonds are listed or not. The recent issuances are mostly listed. However, the enabler of these issues has clearly stated that the liquidity is poor in the exchanges and that you may not be able to actually sell your bond on the exchange. Platforms like Wint Wealth enable you to sell the covered bonds they offered to you, to any other willing party who wants to buy them through their platform. They also state that they will maintain some cash reserve for any small portion that you want redeemed. However, there is no guarantee that you will be able to sell them prematurely. These are products that are ideally held till maturity.

Do Covered Bonds deliver better than FD?

Yes, they do deliver better returns than FDs, but at a higher risk, of course. The risks – specifically the credit risks – are far higher than those attached to an FD.  If you are a bank FD investor and want to treat this as a substitute for your FD, it is a bad idea. When you invest in an FD you are lending to an RBI-regulated bank. In covered bonds, you are lending to an NBFC, whose income depends on repayments from its borrowers. This is the primary reason why you enjoy a higher return from covered bonds. Always remember that higher returns in debt cannot come without taking on higher risk to capital.

The Challenges with Covered Bonds

1/ Covered bonds in the domestic market may not suit all kinds of NBFCs. Investors may have a preference for relatively shorter tenure bonds which would be more suitable for covering via vehicle and gold loans, rather than housing and long-tenure small business loans. The extent of covered bonds that can be issued may also be restricted by collateral available.

Data from ICRA also showed that based on the asset class, gold loans had the highest 46% share in market volume for covered bonds, followed by 28% for vehicle loans, 12% each for small business and wholesale loans, and just 2% for microfinance loans.

2/ The company’s ability to maintain the required security cover would remain important. Failure to meet the security cover would result in a step-up on the coupon rate thereby negatively impacting the financial profile of the entity.

3/ Lack of legislative framework for Covered Bonds in India
A specific law governing the issuance of covered bond in India is not present. Hence, the interim solution for the same is a contractual arrangement under the general law of the country. Till the time specific legislation pertaining to covered bond is passed, the issuance of covered bonds can be governed under the general law on the basis of contractual agreement between the issuer and the investor. In most cases, the retail investor is at a disadvantage and is taking a higher risk.

4/ In a covered bond, an NBFC borrows money from you on a pool of loans it has already made. It is essentially refinancing its loan book. That pool is in turn backed by collateral, which the NBFC can sell to raise the money. The important point to note here is that the pool of loans against which it issues a bond remains in the NBFC’s books and it bears any risk of default in this pool.

5/ Covered Bonds have very poor liquidity for now, even if they are listed. And if you are fine with poor liquidity, you might as well consider floating rate RBI Bonds, or PPF, or EPF investments.

6/ Covered bonds do not have deposit insurance, unlike scheduled banks whose deposits are covered up to Rs 5 lakh per account holder. You will not also have the RBI coming to your rescue if an NBFC that has issued a covered bond goes bust.

7/ Each tranche of bonds/MLDs is issued by different NBFCs that are not large and mostly do not enjoy top-notch credit ratings (they’re usually AA or below). Players like Wint Wealth are enablers/distributors for such NBFCs to offer these bonds. They also play a role in creating the SPV guarantor and debenture trustee to handle disposal of underlying assets. “Guarantors” in this context ensure that the cashflows from the underlying loans reach you in the event of a credit risk. It does not mean they will make good your principal or interest from their pocket if there’s a shortfall. The NBFCs who issue these bonds remain the principal borrowers/ and the pool of loan assets and the property/gold mortgaged remain the only backing.

8/ Covered bonds are unlikely to be used as a fund-raising avenue by top-rated NBFCs, which can easily tap banking or market sources. Usually, NBFCs that are unable to source funding through the regular banking channels or find that route more expensive are likely to raise covered bonds. This is evident from their credit rating. Let’s take Wint Bricks. The NBFC issuing these MLDs is Ugro Capital. Its long-term rating for bank loans is A (which is 5 notches below the highest rating). Let’s take another issuer (gold loan NBFC) that came up with covered bonds in December 20 – Kanakadurga Finance. This NBFC’s rating (March 21) is BBB stable by Care Ratings, this is barely investment grade. A mutual fund holding a BBB rated issuer will receive only brickbats.

9/ The existence of collateral backing bonds, in the Indian context, does not offer certainty of repayment. The assumption here is that the backed assets can be liquidated. As most of us are aware, assets such as properties cannot be liquidated easily. Banks do this for a living and in India, struggle to enforce collateral even from large companies, in the case of default. In the case of collateral like gold, liquidity may be a given but the realizable value may not.  Yes, the difficulty of enforcing collateral exists even in the case of banks or marquee NBFCs. But banks or marquee NBFCs usually have the financial strength to borrow quickly from markets to tide over a cash flow mismatch. For a low credit rated NBFC, access to such funding may be limited.

Challenging the Benefits of Covered Bonds

1/ Attractive interest rate. This is not debatable that covered bonds offer a higher return, but it needs to be understood that it comes with a higher credit risk as we discussed above.

2/ Attractive taxation. The tax loophole arising from linking a product to an unrealistic (and somewhat irrelevant) benchmark may not go down well with the taxman.

3/ The comfort of safety. The comfort comes from the bond being asset-backed. We have explained that being secured by collateral does not make this a safe product.

4/ Bankruptcy protected. We think this is a fallacy. Unless something is sovereign guaranteed (even then there is no zero risk), you cannot not suffer if your issuer is bankrupt. The suffering may come either through delayed repayment or lower repayment.

5/ The simplicity to the whole product. This is the most dangerous part. You go to a platform. You read what is stated in a few lines; click a few buttons and invest. In fact you may not even know the true maturity date if the call option is not honored! A complex product that is oversimplified to reach the retail investor does not become a simple product. It becomes a complex product that is guised as a simple one.

In our view, in covered bonds, only one thing matters, and that is the quality of the issuer.  If you have a high-quality issuer then you will have no reason not to invest. However, then the interest offered may not be high. Democratizing fixed-income assets should not come at the cost of giving retail investors products whose risks are underplayed.

Summary

It is clear now that the Indian financial market is ready for the issuance of covered bond. The introduction of this instrument might open new avenues of investment in the country. A clear legislation on the same would open doors to major growth in our economy. They carry lesser risk as compared to other corporate bonds, since they have a double backing.

Having said that, there is too much theory in this. The reality may be quite painful if the issuer defaults and goes bankrupt. We have already been seeing such signs of stress in our economy.

All in all, Covered Bonds is a complex product that is oversimplified to reach the retail investor, but that does not make it a simple product. It becomes a complex product that is guised as a simple one. 

Overall, covered bonds can be a small allocation for investors with deep pockets who can take on risk to their principal for high yields. This is not a product for a regular income earner or someone looking to hedge their equity risks with debt. This is why these products were earlier only meant for ultra HNIs and family estates.

Regards

Manoj Arora
Official Website