Covered Bonds: Here’s all you need to know

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Domestic covered bond issuances increased dramatically in FY2021 from Rs 400 crore in the previous fiscal year to Rs 2,220 crore in FY2021, noted a report by rating agency ICRA. Non-banking financial companies (NBFCs) have issued nine of these bonds in FY2021, compared to two in FY2020.

Anyone can invest in covered bonds that include central banks, mutual funds, institutional investors, insurance companies as well as retail investors. Many of the wealth advisory services have started offering this option to their investors with a ticket size starting as low as from Rs 10,000.

What are covered bonds?

The domestic covered bond market is still in its early stages, with the first issue occurring in FY2019. This structured instrument, on the other hand, has long been a well-accepted financing mechanism in western markets, particularly in Europe, and is gaining favour in Singapore and Japan as well.

According to a note by ICRA, covered bonds have seen increased acceptance in the Indian market, particularly in H2 FY2021, because they offer the investor “dual recourse,” meaning that the repayment obligation must be met by the entity and, in the event of failure, by a pool of assets assigned to a trust.

“Through the covered bond structures, the entities are able to reduce the risks for the investors by providing an exclusive cover pool of assets assigned to a trust thereby helping them improve the credit rating on such covered bonds to double A or triple A rating categories,” said Abhishek Dafria, Vice President and Group Head – Structured Finance Ratings at ICRA.

What is the structure of the covered bond?

Covered Bonds are issued by NBFCs to all kind of investors. At the end of maturity, the NBFC will pay the principle plus interest to the investors. If the NBFC fails to pay, the money can be reclaimed from the cover pool of secured loans. Even if the NBFCs shut down, money will be recovered from the cover pool.

The biggest advantage as compared to regular bonds is that the covered bond is bankruptcy protected. When investors go for regular bonds, the option of repayment obligation will be or will not be there.

When it comes to the taxation aspect, the product is considered a market-linked debenture (MLD). In short, MLDs are debt assets where returns are linked to market index like Sensex or Nifty.

So, if investors hold covered bonds for more than 12 months, then he or she would be taxed 10% on interest. If investors hold it for less than 12 months, they would be taxed as per the income slab bracket.

Category of investors who can invest in such issuances?

So far, approximately two-thirds of covered bond issuances have been in the form of market-linked debentures. High-net-worth individuals (HNIs) and family wealth offices have invested in such issuances as they look for good returns under the low interest-rate regime.

That said, as the covered bonds are backed by a security pool of gold loans and vehicle loans, it has become more attractive due to the secured nature of the underlying loans.

“For the covered bond market to witness any material increase, participation of other categories of investors would remain critical, such as mutual funds and insurance companies, who have the capacity to participate in large-size issuances,” said Rachit Mehta, Assistant Vice President, and Sector Head – Structured Finance Ratings.