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Covered bonds are rapidly gaining ground in India as investors grow tired of low yields on their debt investments. According to data from Icra Ltd, Indian issuers sold covered bonds worth 2,218 crore in FY21, against  a  measly  25  crore  just two fiscal years earlier. Mint takes a look:

What are covered bonds?

Like regular secured bonds, these bonds too are backed by a pool of assets. However, unlike regular secured bonds, the covered bond issuer transfers these assets to an independent trust which holds them. This means in case an issuer goes bankrupt, covered bond buyers get priority in repayments. They are often called bankruptcy-remote bonds. Again, buyers have two ways to recover their investment—by the issuer directly, or by routing payments directly from the assets, say vehicle or gold loan repayments, to the buyer. This strengthens the creditworthiness of covered bonds vis-a-vis ordinary secured bonds.

Why are these rated higher than issuers?

Given the structure of covered bonds, ratings agencies often assign them a higher rating than the issuer, something called ‘credit enhancement’. This allows the issuer to offer a lower interest rate (coupon) against these bonds. Individual and institutional investors who demand higher ratings can then purchase these bonds. For instance, if an investor buys only AA-rated bonds, even an A-rated issuer can issue covered bonds which get rated ‘AA’, making them an investment option for this investor. Some institutional buyers have limits on exposure to credit enhanced bonds, making wealthy people a bigger market for them.

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Why are covered bonds becoming popular now?

Investors have endured low yields and low fixed deposit rates since early 2020 due to easy monetary policy, and their patience is running thin. The yields on covered bonds, which may be higher than that of non-covered bonds of comparable rating, make them attractive. The structuring of many of these as market-linked debentures or MLDs also confers tax advantages.

What are their tax advantages?

These are taxed the same way as ordinary debt. But many of these bonds are packaged as MLDs. If MLDs are sold after a year, the gains are taxed at 10%. This confers tax advantages to HNIs. MLDs need to have some kind of market linkage, but issuers structure the linkage in such a manner that makes it irrelevant. For instance, a structure saying the bond will pay out 10% if the benchmark government secu-rity retains at least 25% of its value at maturity, and just principal back otherwise, makes it very unlikely that you will get just the principal.

What should investors watch out for?

Covered bonds are a financial innovation in India. Their ratings are often higher than the rating of the issuing entity. In the past, such innovations have sometimes ended in blow-outs. Example: The mortgage-backed securities (MBS) in the 2008 financial crisis. The sectors that are currently issuing covered bonds such as gold lending and vehicle finance are strongly linked to the covid-hit informal economy. The bankruptcy-remoteness of the pool of assets backing these bonds has not been tested in the Indian legal system.

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