Covered Bonds: India’s Newest Debt Market Fad Needs Firmer Ground To Stand On

As the Indian debt markets emerge from the Covid-19 crisis, which followed a series of other accidents — IL&FS, Dewan Housing Finance Corp., the blowout over Yes Bank Ltd. AT-1 bonds — arrangers, issuers, investors are trying to get their mojo back. Collectively, they seem to have settled on covered bonds as the next big thing.

Covered bonds may be new to India but they have been a well-established class of securities in Europe for decades. They are popular in markets in the Asia-Pacific region, such as Singapore and Australia, as well. In comparison, the market in India is tiny but growing.

Data from rating agency ICRA Ltd. shows that between April 2020 and March 2021, non-bank lenders raised Rs 2,218 crore, compared to Rs 400 crore raised in the previous fiscal. Non-bank lenders rated up to ‘A’ have been issuers and high net worth individuals have the most prominent buyers. After the pick-up seen last year, more such issuances are said to be in the works this year.

Covered bonds essentially provide ‘dual recourse’ to investors using a ‘cover pool‘ of assets.

“As long as the issuer is solvent, it is obliged to repay its covered bonds in full on their scheduled maturity dates. If the issuer is insolvent, the proceeds from the cover pool assets will be used to repay the bonds,” explains a 2019 S&P Global Ratings primer on this class of securities.

According to S&P, the earliest known ‘covered bonds’ were introduced in Prussia in 1769 by Frederick the Great, and in Denmark in 1797. Even in more recent times, it is Europe that dominates the issuance of covered bonds globally. One reason for this is that European Union markets have specific legislations which define covered bonds and help enforce the dual recourse structure. These bonds are also exempted from ‘bail-ins’ in the case of stressed institutions and are assigned a lower risk weight.

In other markets, like the United Kingdom and Singapore, where specific legislation does not exist, regulators have put in place frameworks which guide the issuance of these types of securities.

A look at the information memorandum for some of these securities gives us a peak into how they are being pitched.

• These bonds are labelled as secured bonds with either upfront transfer of the cover pool of assets or conditional transfer at the time a ‘trigger event’ occurs. In a number of cases, the transfer is actually conditional with triggers defined based on factors such as ratings, capital adequacy and bad loans.

• Once transferred, this pool of assets is to be put in a special purpose entity and monitored by debenture trustee. Moreover, since this cover provided by this pool is ‘dynamic’ and is to be maintained at a prescribed level throughout, it needs to be constantly monitored and replenished if needed even prior to the transfer.

• These assets in the pool are unencumbered and a certificate to that effect is issued. But no-objection certificates are not sought from unsecured lenders.

• The securities are pitched as being bankruptcy remote based on legal opinion.

The first set of questions being raised pertain to the ‘bankruptcy remote’ nature of these securities. With no mention specifically of these securities in the bankruptcy legislation and no regulations, is it risky to assume that the cover pool backing these securities will indeed be bankruptcy remote?

Vibhor Mittal, chief product officer at CredAvenue — a debt platform which has been arranging covered bonds, says the legal view obtained suggests that the cover pool shall not form part of the liquidation estate. “There is a provision in the Insolvency and Bankruptcy Code, which says that if the debtor is holding an asset in trust for the benefit an investor, then that asset will not form part of the liquidation estate of the entity. This provision further supports the bankruptcy remote nature of the cover pool assets,” he says.

Leena Chacko, partner at Cyril Amarchand Mangaldas backs that view but acknowledges that the position has not been tested.

“The pool of assets, pursuant to the assignment, is removed from the books of the company and is parked in the special purpose vehicle,” she said in a written response. “While the position on bankruptcy remains untested in law, there is ample basis to say it is bankruptcy remote. Regulatory sanctity in the form of law or regulation from Reserve Bank of India or Securities and Exchange Board of India will add more credence to the structure.”

Siddharth Srivastava, Partner, Khaitan & Co., said that while the special purpose vehicle structure is being used to segregate the cover pool of assets, certain issues need to be kept in mind.

“One should be mindful that it should not go against the basic ethos of the ‘covered bonds’ which are premised on the fact that covered bonds are ‘on balance sheet’ transactions,” Srivastava said in a written response. “Therefore, if for any reason (regulatory or otherwise) housing of cover pool of asset is not possible in the SPV because of the very nature of ‘covered bonds’, the risk of insolvency of the Issuer would remain and cover pool of assets may also become a part of the insolvency process of the issuer.”

For now, though, all covered bonds are being issued and rated based on the legal view that these will prove to be bankruptcy remote.

There are few other practices in the issue of covered bonds in India that need careful monitoring.

In the case of bonds which build a conditional transfer, the trigger points where the cover pool is transferred is important. Sitaraman says, at present, in India, the trigger points are set in a way that bankruptcy of the issuer is still some time away. For instance, an issuer’s rating falling to the minimum investment grade may be an early trigger.

But perhaps fearing challenge to these conditional transfers, institutional investors are preferring upfront transfers, acknowledged Mittal. “Institutional investors prefer the upfront assignment structure. Concerns around clawback of assets/preferential or fraudulent transfer is lower in the case of upfront assignment compared to conditional assignment where the transfer could happen much closer to a bankruptcy event.”

Two fund managers, who spoke on condition of anonymity, also raised the practicality of debenture trustees being able to monitor the adequacy of the cover pool and ensuring it is topped up in time. In some markets in Europe, for instance, ‘cover pool monitors’ ensure that this done. In India, the debenture trustee framework hasn’t always proved to be robust and that's a risk factor, said one of the fund managers quoted above.

Finally, given the lack of regulatory and legislative certainty around these securities, the investor class that they are pitched to is important to watch.

Debt investment platforms like ‘Wint Wealth’ are pitching these securities to what they call the mass affluent segment, with a minimum investment size of Rs 10,000. While the platform does mark the risk level of these securities as higher than that of fixed deposits and bond funds, whether retail investors understand the untested nature of these securities is an important factor to keep in mind. The miss-selling seen in the case or AT-1 bonds must be staved off.

Needless to say, it would be best if clear rules come from SEBI or the RBI, which help in setting guard rails for these securities and help the market grow safely.

Ira Dugal is Executive Editor at BloombergQuint.