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Created on 26.06.2019

Covered bonds: mortgage bonds for cautious investors

Investors who only want to assume a low level of risk focus on fixed-interest securities. Here, investors can lend money to a state or business and receive regular interest payments for doing this. At the end of the term, the deposited amount is paid back to them as long as the debtor is not insolvent. A covered bond, which is considered one of the safest investments, is a classic fixed-interest investment.

Despite the high degree of security they offer, covered bonds have been losing their appeal. Due to the expansionary monetary policy implemented by various central banks, interest rates have fallen to extremely low or even negative levels. New issues of covered bonds are purchased almost exclusively by institutional investors such as pension funds, asset managers and insurance companies. The interest rates in the current environment are too low for the majority of private investors. If you are looking for something secure and which will maintain its value, you should look into this investment opportunity.

Top rating – high security

Covered bonds are among the safest investments on the market. Generally, they are bonds that are collateralized with domestic mortgages. In other words, covered bonds are backed by tangible assets. Covered bonds are issued by a Pfandbrief or mortgage bank.

The high level of security is reflected in the rating. Various rating agencies have given Swiss covered bonds the top rating of AAA. These securities have actually never received a rating lower than AAA in Switzerland. You can find out more on this topic in the article “What are ratings?”. Various factors are considered in awarding this top rating:

Besides the liens, the continuous monitoring of the cover pools as well as the creditworthiness of the debtors also play an important role. But the high creditworthiness also has its price: high-quality debtors have to pay less interest than those with worse credit ratings. This is why covered bonds pay less interest.

Starting point – commercial banks want to refinance mortgages

If a bank wants to refinance part of the mortgage loans via central mortgage institution loans, it can do so by issuing a request to a mortgage bond institution. They check whether the mortgage in question fulfils the strict Swiss Mortgage Bond Act criteria. If the outcome is positive, the mortgage bond institution grants a central mortgage institution loan to the bank. In return, the underlying mortgages are pledged and set aside. Subsequently, the mortgage bond institution issues a covered bond backed by these pledged mortgages. Usually mortgages from various banks are pooled for a covered bond. That way, the bonds are usually well diversified regionally.

Differences to other countries

There are interest-bearing securities in other countries too, which have the same structure as Swiss mortgage bonds and fall under the umbrella term “covered bonds”. Among the various types of covered bond issued abroad there are, however, significant differences in relation to issuance, coverage and the system. From an international perspective, Switzerland has some of the strictest regulations when it comes to covered bonds and their coverage. Here in Switzerland, only two institutions may issue covered bonds, according to the special bank principle. This differs from other countries. In many countries, any financial institution can theoretically issue covered bonds. This means the market lacks transparency, making it riskier.

In Switzerland, the lending limits are chosen conservatively: a bank can only refinance up to two-thirds of a mortgage via covered bonds, whereas in other countries in Europe, the lending limit is higher. In Spain, for example, banks can refinance up to 80% via covered bonds. The securitization of mortgage debt, which led to the 2008 financial crisis, differs from the traditional and conservative Swiss covered bonds in one key respect: the risk of the payment default is passed onto the purchasers of these securities, if a debtor cannot pay their mortgage any more. You can find more information about the financial crisis in the article “2008 financial crisis – a review and the lessons learned.

Another difference lies in in the mortgage bond system. The covered bank bonds in Europe include specific characteristics of the issuers. For example, if the creditworthiness of a foreign bank deteriorates, this can have a negative impact on their covered bonds. By contrast, Swiss covered bonds are diversified across around 323 mortgage bond banks that are members of the Pfandbriefbank schweizerischer Hypothekarinstitute as well as the 24 cantonal banks of the Pfandbriefzentrale. The member banks bear liability with all of their assets for the incurred liabilities from the central mortgage institution loans and for the mortgage bond institutions.  

The covered bond is as solid as a rock

Those who invest in covered bonds enjoy four levels of security. Firstly, the mortgage bond institution bears liability for the security with its assets. Secondly the investor has the option of falling back on the commercial banks who issued the mortgages, if the mortgage bond institution declares bankruptcy. Thirdly, if the commercial banks in question declare bankruptcy, the mortgage debtors bear the liability. If finally even the debtors cannot repay the mortgage, the property values serves as a fourth and final level of security. Thanks to this comprehensive security, there has not been a single covered bond issue failure recorded in the entire history of the Swiss Mortgage Bond Act, which dates back to 1930.

Covered bonds are also suitable for private investors

Covered bonds are fixed-interest bonds, which promise interest payments and repayment of the face value. They are liquid investments and are traded on the stock exchange. The maturity period is between two and twenty years.

With a denomination of CHF 5,000, covered bonds are securities that are also suited to private investors. Yet, this type of investment has not really been taken up by private investors. It is primarily institutional investors such as pension funds, asset managers and insurance companies who invest in covered bonds. 

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