Covered Bonds and Pfandbrief

Covered bonds are fixed-income securities (debt instruments) backed by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default. The fact that investors are secured by a collateral pool in addition to the issuer’s creditworthiness makes Covered Bonds a very conservative instrument to which typically (though not always) AAA credit ratings are assigned. The German Pfandbrief has become the blueprint of many covered bond models in Europe and beyond. The Pfandbrief bond market is the biggest segment of the private bond market in the world, equalling about 900 billion Euro in volume outstanding.

Usage and Characteristics

Covered bonds are increasingly used in the marketplace as a funding instrument, in addition to savings deposits, mortgage-backed-securities, etc. The issuance of covered bonds enables credit institutions to obtain cost-efficient funding in order to grant mortgage loans for housing and non-residential property as well as, in certain countries, to finance public debt, ships and aircrafts. The portfolio investor has the advantage of investing in safe bonds with a relatively high return. Thus, covered bonds play an important role in the financial system as the main source of financing for real estate loans and municipal debt and constitute a 3.3 trillion US Dollar market.
Covered bonds are issued on the basis of legal or contractual frameworks. The debt and the underlying asset pool remain on the issuer’s financials, and issuers must ensure that the pool consistently backs the covered bond.[1] Thus, covered bond issuers remain ultimately responsible for the performance of the loans being funded. About 40 percent of total outstanding bonds are “jumbo” issues, which are typically large (at least 1 billion Euro outstanding) and to which a minimum number of market makers have committed to quote continuous two-way prices, ensuring their liquidity by trade in a (liquid) secondary market. All these features suggest that Covered bonds are seen not so much as an instrument to obtain exposure to credit risk, but rather as a higher-yielding alternative to government securities.
In the European Union, covered bonds are further defined by the Capital Requirements Directive (CRD), which limits the range of accepted collateral to debts of (highly rated) public entities, residential, commercial and ship mortgage loans with a maximum loan-to-value ratio of 80% (residential) or 60% (commercial), and bank debt or mortgage-backed securities (MBSs).

The German Pfandbrief

With 900 billion Euro in volume outstanding, the Pfandbrief bond market is the biggest segment of the private bond market.[2] The Pfandbrief market is made up of registered Pfandbriefe, traditional bearer Pfandbriefe, and Jumbo bearer Pfandbriefe, with each segment accounting for about one third. The issuance of Pfandbriefe is governed by the provisions of the German Pfandbrief Act, providing Pfandbrief investors with a close-mesh safety net. All Pfandbriefe are gilt-edged, eligible as trustee securities, and eligible as collateral within the scope of open-market operations with the European Central Bank. The credit history of Pfandbriefe is impeccable. Not one case of Pfandbrief default has been recorded since the Mortgage Bank Act, the predecessor of the Pfandbrief Act, entered into force over 100 years ago. The Pfandbrief Act of 2005 which supersedes all prior existing Pfandbrief legislations increased potential issuers to include all licensed credit institutions that meet certain requirements. Formerly, only specialised private mortgage banks and public sector banks could issue covered bonds in Germany.
The Pfandbrief Act expressly specifies which loans meet the criteria to qualify as cover assets for Public, Mortgage and Ship and Aircraft Pfandbriefe. The mortgage lending value takes into account only the long-term, sustainable features of a property; thus, it must not exceed the market value and is often clearly below it.  Of a property’s mortgage lending value only a maximum of 60 % may serve as cover. In addition, overcollaterlisation is legally prescribed so that the Pfandbrief banks must maintain excess cover of at least 2% of the nominal and the net present value of the Pfandbriefe outstanding. The loans collateralising Pfandbriefe are segregated into separate asset pools in the issuing bank’s books which do not participate in insolvency proceedings in respect of the bank’s assets. Tight supervision ensures that the mandatory cover for the Pfandbriefe exists and is maintained.
Following the strong development in issuance due to the launch of the Jumbo in 1995 and the advent of the Euro in 1999, a number of jurisdictions in Europe (including many eastern European countries) have now established the regulatory framework for Pfandbrief-style products.[3] Apart from Germany, Spain, Denmark and Sweden passed laws providing a framework for the issuance of these products already around the start of the last century or even before. In all countries, the corresponding laws aim at guaranteeing the quality of covered bond instruments with a view to reproducing the popularity and attractiveness to investors of the German Pfandbrief, also at the international level. The adaptation of national laws to the German model is being pursued in the light of the fact that the strong characterisation of Pfandbrief as a quality product has allowed it to obtain a unique, almost privileged, position at the European level compared to other high-quality non-sovereign assets. This privileged position is reflected in relatively lower swap spreads of Jumbo Pfandbrief in comparison to Covered Bonds.

Pfandbriefe/Covered Bonds and Mortgage Backed Securities (MBS): The Differences[4]

While the Pfandbrief is a classical on-balance sheet refinancing tool of mortgages and public loans with both origination and issuance completed by one and the same entity, MBS transactions are off-balance sheet transactions and involve at least one more party (besides the mortgage originator). Pfandbriefe serve primarily as funding instruments, whereas MBS issues are also employed for credit risk transfer and balance sheet restructuring, with the aim of efficient management of economic and regulatory capital. Originators of MBS sell contingent claims on asset cash flows in order to remove and legally segregated ('bankruptcy remote') reference portfolio of securitised assets from the balance sheet. In contrast, in a typical German Pfandbrief transaction, reference assets are 'ring-fenced' on the balance sheet of government-licensed issuers and repayments to investors are independent from the repayment of securitised assets. Issuers of Pfandbrief deals are fully liable with their registered capital if reference assets fail to generate sufficient cash flows for the repayment of investors. Hence, this arrangement implies a double protection of investors against credit risk and the solvency of the issuer. Given the value of this institutional guarantee depending on the issuer's financial strength, Pfandbrief transactions generally receive high ratings. However, in comparison, MBS transactions are devoid of any institutional guarantee and solely return cash flows generated from the pool performance of the designated reference portfolio. Issuers of MBS transactions compensate issuers for the higher asset exposure due to the lack of institutional protection by including various kinds of internal and external liquidity and credit support, such as bridge-over facilities, surety bonds, third-party guarantees, excess spreads, over-collateralisation and reserve accounts. Finally, Pfandbrief issues are typically subject to stringent laws (requiring a weighted average loan-to-market (or appraised) value (LTV) of at least 60 per cent as a statutory benchmark), while private-label MBS issues are free from these legal requirements, except in so-called agency-MBS in the US, where the quasi-government agencies Fannie Mae (FNMA), Freddie Mac (FHLMC) and Ginnie Mae (GNMA) provide institutional guarantees in return for certain restrictions imposed on mortgages eligible for purchase in MBS structures.

Critical Acclaim

With the introduction of the Jumbo and the Euro, Covered bonds have developed from a national instrument to an important segment of the European bond market. Especially the launch of the Jumbo, its increased level of standardisation and enhanced liquidity characteristics, attracted the interest of international investors wishing to access liquid and secure instruments carrying competitive yields.[5]
However, there have been critical analyses of the ‘real’ quality of Pfandbriefe or rather the issuers behind them, especially in view of the modern financing instruments (derivatives) that the Pfandbrief institutes use to close open positions.[6] Assessing the value added by the cover pool is indeed not straightforward. While both covered bond legislation and the contractual arrangements underlying structured issues contain numerous provisions to ensure that the cover assets retain their value in the event of the issuer’s bankruptcy, few if any of these provisions have been tested in court.
In addition, the lack of uniformity between the different Pfandbrief-style products of the individual countries in Europe is still perceived as being a drawback by international investors.

Covered Bonds in times of financial and real estate crises

The real chance of a Covered Bond issue defaulting even in an unprecedented environment is considered to be very low. For the Pfandbrief, not one case of default has been recorded since more than 100 years.
Indeed, in the financial and real estate crisis of 2007-2009, so far no covered bond issue failed. Because Covered Bonds are on-balance sheet refinancing instruments they are even perceived as help to redress some of the fundamental incentive problems that contaminated the economic rationale of securitization.[7] In a move to stabilize credit markets afflicted by the demise of securitization, authorities in several countries have drawn up plans to encourage the issuance of covered bonds as an alternative source of capital markets-based funding. Paradoxically, however, general financial sector inventions aimed at unfreezing interbank lending markets (i.e., state guarantees of bank bonds) have seriously undermined the ability of lenders to use covered bonds to fill the void of unmet credit demand left by dysfunctional securitization markets. After renewed financial market turbulence in September 2008, the primary market for covered bonds has virtually shut down as new issues have been squeezed out by state-guaranteed bonds and unsecured bank bonds (that also benefit from state rescue programs but provide a yield pickup). Secondary market prices of covered bonds remained also depressed while credit spreads widened. In consideration of this problematic situation, the European Central Bank decided on 7 May 2009 to purchase euro-denominated Covered Bonds issued in the euro area for an amount of EUR 60 billion, distributed across the euro area and carried out by means of direct purchases. This Covered Bond programme as well as the overall improvement in the credit markets has helped to revitalise the primary market and to significantly reduce the credit spreads. By 2010, the market for Covered Bonds has almost returned to normal. The first quarter in 2011 even showed a record high in new emissions. This current popularity is mainly based on the favourable regulatory treatment of Covered Bonds in Basel III and Solvency II.

[1] In the following cp.: Orazioa, Maestroeni: Pfandbrief-style products in Europe, s.l. 2001, pp. 44-46. In the following: Orazio, Pfandbrief-style.

[2] In the following cp.: Verband Deutscher Pfandbriefbanken: The Pfandbrief. A Safe Investment, Berlin 2008.

[3] In the following cp.: Orazio, Pfandbrief-style, p. 44 & pp. 47-52.

[4] This chapter is copied from: Jobst, Andreas A.: A Primer on Structured Finance, in: Journal of Derivatives & Hedge Funds, Vol. 13, No. 3, 2007, p. 207.

[5] Cp. Orazio, Pfandbrief-style, p. 52.

[6] In the following cp.: Packer, Frank/ Stever, Ryan/ Upper, Christian: The covered Bond Market, s.l. 2007, p. 52.

[7] In the following cp.: Jobst, Andreas/ Kiff, John/ Spackman, Carolyn: Financial rescue and regulation, a Global Crisis Debate, s.l. 2009.

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Countries with Legislation on Covered Bonds

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United Kingdom
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