Benefits of Covered Bonds over Unsecured Bonds - Essay Example

Name of the student: Course Tittle: Name of the professor: Date 1.0 Introduction a) Bonds A bond can be defined as a debt security in the market similar to other securities like I.O.U and other securities. Whenever investors purchase a bond, it lends money to the government, a corporation, a municipal or federal agency that is well known to the issuer. Bonds that are issued by corporations are taxable while once which federal government or municipal issues are exempted from tax (Kidwel and Johns 2010). A bond consists of the following components; i. Bondholder ii. Principal amount iii. Interest rate that is paid to the issuer annually iv. Date of maturity b) Shares Shares are type of equity security. The owner of the share owns one part of the capital of the company that has issued him or her with the shares. The shares gives shareholders the right to take part in the decision making process of the company and it depends on the type of shares one owns in the company (Kidwel and Johns 2010). If the company earns profit, the shareholders will earn dividend depending on the amount of dividends declared by the company directors. 2.0 Types of Bonds Bonds can be classified in different ways they include; Government bonds: The government to raise more money to finance its projects using fixed security incomes. They include Notes, bills and treasury bills. Municipal bonds: are issued by municipals to raise more funds internally to fund their project. They are more secured compared to corporates bonds but less lucrative compared to government bonds. They take long before they mature. Corporate bonds: These are bonds issued by companies in the same manner they issue shares. The corporate bonds are maturing faster compared with both the municipal and government bonds. Corporate bonds are subjected to tax whereas municipal and government bonds are not. They are less secured compared with municipal and government bonds (Kidwel and Johns 2010). Another classification of bonds is covered and unsecured bonds. Covered bond are secured debt instruments and are normally issued by credit institution either as part of a single issuance and sometimes as a program by the financial institutions (ECB, 2008). Unsecured bonds are issued by corporates and are exposed to other economic changes like tax and inflation. Covered bonds are low risk interest bearing products with high maturity rate of more than one year and less than 30 years while secured bonds are less secured and mature faster compared with covered bonds. Covered bond are also defined as one, which is backed with a pool of high quality security assets coming from the issuing banks (ECB, 2008). The covered pool consists mostly of relatively low risk assets and includes residential mortgages and public debts while unsecured bond consist of high-risk assets. The law requires the issuance bank to retain at least equal amount of the outstanding value of the covered bond. Therefore, it adds to the number of assets to the covered pool in order to compensate for any decline in the quality of assets, which are in the pool. The assets in the pool are segregated from the bank other assets so that covered bond investors are in a position to enforce their security interest over those assets in the events that the banks default (Reserve Bank of Australia, 2013). The recourse of the covered bondholder in this pool is the major distinction between unsecured bond and covered bond. In the event of a default, the holders of the bond have the preferential recourse to a specific asset that is known as the cover pool. The multiple recourse nature of the covered bonds normally seeks to ensure that the bonds withstand any distress that is experienced by the issuer, or that is caused by any underlying collateral. If unsecured bonds and other securities compare the covered bond, the covered bond is more superior to any other market securities (Reserve Bank of Australia, 2013). Covered bond has dual-recourse bonds with a claim on the issuer and covered pool of high quality collateral that, throughout the bond term, dynamics is required by the bond issuer. In order to maintain the quality if the specified assets, the issuer pool must be reignited by issuing new assets. Covered bond do pay fixed rates and have a longer maturity period compared to unsecured bonds; they take 3-15 years to mature. Covered bond provide investors with the priority in the event of failure to claim cover pool of issuer of the bond something that is not available. The covered bonds, if compared with other security in the market, are considered more superior (Reserve Bank of Australia, 2013). Origination standards- the originator of the assets should retain the underlying asset in the balance sheet. The originator standards encourages a more stringent underwriting processes and adds to quality of the security of the underlying the portfolio. It has no risk transfer it has independent of the performance of the collateral, in this scenario, the issuer responsible for repaying the covered bonds. The bond has dynamic pools since non-performing loans from the underlying pool of the asset and can be substituted for performing loans within the pool. The bond has no need to subordinate tranches in order to reduce the exposure risk hence more secured compared with other sources. Benefits of covered bonds over unsecured bonds Covered bonds are more abundant sources of fund compared to unsecured debts and other MBS; it plays a key role in offering more capital to the lending banks hence most preferred by investors (European Systemic Risk Board, 2013). The covered bond offer diversification in security investments compared to other sources of security they offer access to; New credit investors Insurance companies and asset managers and also Investors in foreign debt and the government-backed debts as the government sponsored entities. The covered bond gives investors fixed duration as this improves asset liability management by adding finding certainty compared to other sources of securities Covered bond loans in the cover pool should remain back in the covered pool in the pre-transaction value of the balance sheet as this is similar with the issuers of MBS that holds their initial loss. It is a contrast in case the sale of accounting takes place in a depressed market condition resulting into realization of losses. Other roles of covered bond which makes it popular over other bond types include It appeals to credit institutions due to security due to cost efficiencies and effectiveness to more established credit institutions in the bond markets as they play a role in strengthening the balance sheet by allowing equal competition in the market (European Covered Bond Council 2013). Most of the issuer discretion over the replacement quality of cover pool assets during the lifetime of a particular issue that is capable of influencing refinancing and the credit risk involves. However, covered bond have limited float rates during issuance while unsecured bods do not have unlimited float Covered bond has limited liability that is hedged the combined sovereign swap result of defaults of issuer due to risk exposure and asset based liability while unsecured bonds do not (PriceWaterhouseCoopers, 2012). Shares Shares are interest of members in a company; a company may have different types of shares depending on the condition attached on them. In general, there mainly two types of shares they are ordinary shares and preference shares (Kidwel and Johns 2010). Ordinary shares are the most common type or class of shares in most of the companies. Ordinary shareholders carry voting rights and shareholders are entitled to varying rates of dividends. The shareholders are getting dividends out of Profit Company has made (Kidwel and Johns 2010). On the other hand, preference shares are shares that have preferential rights over ordinary shares and this is in respect to dividend distribution. The specific rights and benefits accrued to preference shareholders are normally commercial decisions which are decided by each company. These decisions are contained in the memorandum of association, member’s resolution or article of association. Firms have the right to not issue out preference shares of convert any issued shares into preference shares unless there is any relevant right that pertains to the preference shares in question that have been set out in the company memorandum or the article of association. They include voting rights on whether the dividends which are associated are either accumulative or are non-accumulative and also whether there is a right to participate in the company surplus profit or not(Kidwel and Johns 2010) While ordinary shareholders are the least to be given their dues when the company is liquidating, they are also the people who can enjoy most of the profit the company has made in times of winding up (Kidwel and Johns 2010). The capital structure theory helps investors to choose the type of investment in security markets. In their seminal work on capital structure (ir) relevance Modigliani and Miller (1958) show that the way a firm finances its investments does not matter for the market value of the firm. It is irrelevant whether companies choose to issue equity, straight debt, convertible bond or any other package of securities to finance their investments. In terms of the firms underlying equity valuation of the company reacting differently to the issue announcement and the type of the security(Kidwel and Johns 2010). Conclusion and recommendation Depending on the nature and objectives of the company, the underlying concept in generating more funds to the company depends on the business structure and the company ownership. If the company does not want to dilute the ownership of the company, they will not offer ordinary shares but buy bonds to raise more company. In case the company needs quick funds to fund its project, then issue of shares will be more appropriate hence, the nature and choice the nature of security will depend on the company need. Reference European Central Bank (2008), Covered bonds in the EU financial system, http://www.ecb.int/pub/pdf/other/ coverbondsintheeufinancialsystem200812en_en.pdf European Covered Bond Council (2012), ECBC Fact Book 2012, http://ecbc.hypo.org/Content/default. asp?PageID=501 European Covered Bond Council (2013), “About Covered Bonds”, http://ecbc.hypo.org/Content/Default. asp?PageID=311 European Systemic Risk Board (2013) Recommendation of the ESRB of 20 December 2012 on funding of credit institutions, http://www.esrb.europa.eu/pub/pdf/ recommendations/2012/ESRB_2012_2_annex.en.pdf?c2 f41dbbc364c483fe2d8e35adef0489 ISBN: 9781742166629 Kidwel N. and Johns K (2010) Financial Markets, Institutions and Money PriceWaterhouseCoopers (2012), Uncovering covered bonds, http://www.pwc.com/en_GX/gx/banking-capital-markets/ assets/pwc-uncovering-covered-bonds.pdf Reserve Bank of Australia 2013) Bulletin, Vol. 76, No. 2, June 2013 Business journal Read More