Covered Bonds

There are different refinancing debt instruments available in the financial market. Issuers can choose any type of debt instrument to raise capital based on their requirement. Also, this gives different investors opportunities to invest in various instruments creating a portfolio for them. Moreover, debt securities make a good addition to all types of portfolios. In this article, we will discuss about hybrid debt instruments, i.e. covered bonds.

What are Covered Bonds in India?

Covered bonds are a type of hybrid debt instrument between asset-backed securities, mortgage-backed securities and traditional secured corporate bonds. In other words, these debt securities are issued by banks or NBFCs, which are collateralised against a pool of assets. 

The bank or NBFC pays principal and interest to investors till the maturity of the bond. In case of payment failure, the amount can be recovered from the pool of assets. Usually, the cover pool of assets consists of housing loans, vehicle loans, gold loans, etc. 

Unlike secured bonds that provide recourse against the issuer, covered bonds provide a dual recourse. Firstly, it provides recourse against the issuer and secondly, it is bankruptcy-protected recourse against the assets of the issuer (Cover Pool). Therefore, due to the cover security, these bonds provide credit rating upliftment over and above the credit rating of the issuer. 

Who Issues Covered Bonds in India?

The following are the entities that issues covered bonds in India

• Banks
• Non-Banking Financial Institutions (NBFCs)
• Corporates

Types of Covered Bonds in India

There are two types of covered bonds in India – 

1. Legislative CBs – Issuers offer these bonds under a specific legal framework that endures all the specificity of the CB law.
2. Contractual CBs – Issuers offer these bonds under general law on a contractual basis. 

A contractual CB has all the features of a legislative CB bearing the critical aspects of structure, management principles and eligible assets from CB law. However, the main difference is that the regulator supervises the legislative CB under a specific legal framework (that complies with all obligations).

Who are the Main Investors in Covered Bonds?

The investors in these bonds are classified as small investors to large institutional investors. These investors aim to invest for a long maturity period and are willing to take a low risk. The following are different investors of covered bonds – 

• Central Bank
• Bank Treasury
• Pension Fund
• Insurance Company
• Asset Managers

These investors have a preferential claim against the dedicated pool of assets or proceeds of these assets. This is a dedicated pool that supports covered bonds to protect the funds of investors. Therefore, investors can exercise full recourse against the issuer. 

Regulatory Framework For Covered Bonds

Presently in India, there is no specific law relating to the governance of covered bonds. Hence, the interim solution for covered bonds is a contractual arrangement that comes under the general law of India. Till the law passes, the issue of these bonds can be related under the general law subject to a contractual agreement between the issuer and the investor. Therefore, the Contract Act, 1872 provisions will be applicable. 

Because of no legislation, the following are some practices for covered bonds – 

• Issuers have to follow consistency across all procedural aspects. For this, some specific standards can be laid in the financial market.
• While issuing these bonds, it is easy to use similar available templates at the time of making documents. This makes the identification and regulatory requirements relating to these bonds simple.
• The issuance of these bonds will come under the model of Special Purpose Vehicle (SPV)
• There should be a set of standardized rules concerning SPV, maturity period, regulatory controls, security, collateral, disclosure requirements and other related factors. 

Recently, RBI has agreed to introduce the concept of covered bonds as this will provide new funding ways in the financial market in India. However, it also mentions that there is a requirement of legal precision and legal framework to successfully issue these bonds in the Indian market. Moreover, SEBI has also given confirmation for these bonds where they would come under the “Bonds” purview in section 2(h)(i) of the Securities Contracts (Regulations) Act, 1956.

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