FI Analysis 16: How do covered bonds function?

This FI Analysis describes how Swedish covered bonds function, how the regulation governing the cover pool is designed and how the cover pool is affected by a fall in house prices.

In Sweden, the largest part of banks' lending to households consists of mortgages where the home is used as collateral. Swedish banks finance a large portion of this lending by issuing covered bonds. A bond is an interest-bearing, current debt instrument. An important difference between covered bonds and other bonds is that the holder of a covered bond has a special right of priority in a cover pool in addition to the claim on the bank if the bank were to fail. This cover pool consists of assets, primarily mortgages, listed on the bank's balance sheet but that by law are held separate from the bank's other assets.

Investors that invest in covered bonds have several layers of protection. The key components in the credit risk of covered bonds are, in order of importance, the issuer's ability to make its payments, the borrower's ability to make its payments, and the value of the underlying collateral, i.e. the residential properties pledged as collateral.

As the cover pool largely consists of Swedish mortgages, its value is affected by developments on the housing market. A sharp fall in house prices would affect the value of the cover pool for the covered bonds. If the cover pool is insufficient, the bank may take measures, such as adding new loans or substitute assets. However, the bank's access to market funding can be affected by developments on the housing market, which in turn could have an impact on financial stability.

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