Covered Bonds in Nigeria
In spite of the global financial meltdown, certain financial products remain the lifeblood of the international capital markets and covered bonds are one such product. A covered bond is a full recourse debt security issued by a corporate institution secured against a specific pool of assets. The United Kingdom Covered Bonds Regulations defines covered bonds as “a bond in relation to which the claims attaching to that bond are guaranteed to be paid by an owner from an asset pool it owns”.
Of German origin, covered bonds have been a major feature of the European capital markets since the mid 1990s. An estimated €130 billion worth of covered bonds was issued in the European market in the first half of 2011. More recently, the United States has welcomed the product, which has been endorsed by the United States Treasury, and a Bill introducing covered bond legislation is presently before Congress.
In Nigeria, the closest products are its ‘plain vanilla’ counterparts - corporate bonds or asset-backed securities. Our capital market regulators have spoken at length about deepening the capital markets and should look to products like covered bonds, which can drive the participation of financial and mortgage finance institutions in the capital markets.
A new asset class
Due to their nature, covered bonds are mostly issued by financial institutions because they have the requisite assets (public sector loans and mortgages) to be utilised as ring-fenced assets. From this perspective, covered bonds will be particularly attractive in the Nigerian market because of the reforms in the banking sector, which has boosted investor confidence in the sector. Globally, the market is moving towards accepting covered bonds issued by non-financial institutions and any efforts to introduce these products into the Nigerian market should aim to cover a broad class of potential issuers/assets. The proposed United States covered bond legislation for example, would also include auto loans, credit card receivables, student loans and government guaranteed small business loans as qualifying assets for covered bond issues.
The unique nature of covered bonds can be illustrated with the banking sector. To fund their operations, Banks can borrow from individuals (deposits), other banks (the interbank market) or from the Central Bank. Banks can also issue debt securities in the form of corporate bonds or asset-backed securities. These funding options have various shortcomings: Interbank borrowing rates are relatively high, while the prices of bonds have gone down. In the asset-backed securities class, the securitisation market in Nigeria is still at infancy, and investors may have little trust in relying solely on bank’s assets.
Covered bonds address these shortcomings at various levels: unlike a securitisation, covered bonds afford investors greater protection because a bondholder has recourse to the cover assets as well as other unsecured assets of the issuer. Furthermore, due to their zero-default status (a benefit of their over-collateralised structure), covered bonds would be cheaper than borrowing on the Interbank market, and will also yield more than corporate bonds and have a longer tenure.
Issuing covered bonds
Covered bonds can either be issued under a regulated framework or be independently structured. Regulated covered bonds are bonds issued subject to and under an established law or regulation which stipulates various requirements and criteria for the issuance of covered bonds. On the other hand, covered bonds are said to be ‘structured’ when they are issued in the absence of a legal and regulatory framework, for example, structured unregulated covered bonds were issued in the United Kingdom before regulations were passed to govern the sector. Structured covered bonds can also be issued where there is a regulatory framework but the issuer wishes to avoid some of the strict requirements of regulated covered bonds.
In terms of deal structures, covered bonds are generally issued as integrated covered bonds or segregated covered bonds. Under the integrated covered bond structure, the issuer is the entity holding the pool of assets and issues covered bonds to covered bonds investors. Under the segregated structure, the issuer sets up a Special Purpose Vehicle (“SPV”) which acquires the asset pool by way of equitable assignment (characterised as a ‘true sale’) using an Intercompany loan provided by the issuer. The Issuer issues the covered bonds to covered bond investors while the SPV guarantees the issue and pledges the cover pool as security for the guarantee.
The conceivable advantage of using the SPV structure is that there might exist legal and structural enhancements at SPV level such as liquidity facility, independent trustees etc. In Nigeria, the legal framework for insolvency lacks sufficient depth to afford investors protection in the integrated model. As such, the segregated model would be better utilised in our markets.Why are Covered bonds attractive?
From an investor’s perspective, covered bonds are more secured than corporate bonds or asset backed securities. This is due to the fact that they have a specific group of assets supporting the securities on a senior claim basis. Thus investors enjoy an extra layer of protection in the securities. Investors also would have recourse to the issuer on a standard contractual basis in the event of default of the issuer.
Covered bondholders are not exposed to prepayment risk because covered bonds are usually structured on a bullet repayment basis (principal is repaid in a single payment at maturity) due to the fact that the assets are typically not cash-generating in the traditional sense and cannot be replenished as such.
Investors would be attracted by the perceived reliability of covered bonds because they generally pay fixed rates and have bullet maturities unlike asset-backed securities and corporate bonds. Furthermore, despite bearing similar zero-default status, covered bonds would typically have a higher yield than government bonds.
Another attraction is that because the assets remain on the issuer’s balance sheet rather than being securitized and sold to the market, the issuer avoids the concept of selling such assets, which is very unpopular on the global stage.
From an issuer’s perspective, covered bonds are a cheaper source of funds than other sources of borrowing including standard corporate bonds due to lower risk of default. As a result of their features, covered bonds enjoy higher rating, typically ‘AAA’, which attracts a diversified investor base to subscribe to the issue. Typically, the maximum rating is often easier to attain if the assets are segregated by using the segregated covered bonds structure because of the independence of the rating from the issuer’s corporate rating.
Another feature that makes covered bonds attractive is that they are highly liquid instruments and have been measured as having the same level of liquidity as government bonds in some instances1. Covered bonds may therefore count towards banks liquidity ratios in the same way Central Bank of Nigeria Guidelines classify qualifying State Government Bonds as liquid assets of Banks. If the Central Bank recognises the importance of covered bonds to the market, similar guidelines could be issued granting covered bonds liquid asset status which would encourage greater investment by other financial institutions covered bonds.
Covered bonds are not entirely risk-free securities. It is worth noting that however rare and remote, a situation could occur where the issuer is unable to meet its debt obligations because the underlying assets default, and in such circumstances, investors will be left with no security to hold unto.
Another challenge is that the underlying assets typically utilised for covered bonds is mortgages. Unfortunately, the mortgage sector and market in Nigeria does not operate on the scale required to make a real impact due to high interest rates which significantly limits the number of people who can access mortgages. Without a significant mortgage pool, covered bond assets would be largely limited to public sector loans, which would not provide a sufficient asset base for these structures. This supports the trend towards market and regulatory acceptance of covered bonds issued by non-financial institutions.Conclusion
The growth of capital markets must be driven both by informed regulators and active operators. In considering ways to achieve its objectives of expanding and growing the Nigerian Capital Markets, the Securities and Exchange Commission could look to passing regulations for covered bonds, which can to an extent be undertaken without recourse to the Investments and Securities Act. Such regulations would specify eligibility criteria for the ‘covered’ assets, issuer requirements, minimum collateral requirements, investor protection amongst others.
The first steps would be recognising the opportunity to deepen the capital markets through securities such as covered bonds and exploring the benefits and how workable this structure could be.
1Danish Central Bank study conducted in 2010
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