It is important to note that covered bonds are generally collateralized by residential and commercial real estate loans that have a longer maturity than the covered bonds themselves. This maturity mismatch between assets and liabilities exposes covered bondholders to refinancing risks. If the issuing bank can no longer meet its payment obligations, bondholders become entirely dependent on payments made on the underlying pool of mortgage loans for full and timely repayment.
This exposes investors to the risk that, to pay on time, the assets in the hedge pool will have to be sold at settlement prices below market value. At current levels of higher interest rates, this would likely add to the overall declines in the market value of longer-term fixed-rate mortgage loans originating from years of low interest rates.
The alternative for a full or better recovery of the collateral pool would then be for investors to wait longer for the mortgages to be paid off gradually over time. This has the consequent side effect that investors may not be able to reinvest these redemptions at a time when interest rates and market circumstances are more favorable to do so.
Several legal safeguards mitigate refinancing risks related to these mismatches in asset and liability maturities. Most secured bonds have twelve-month soft extension features. Subject to strict conditions, redemption of a covered bond may be postponed by twelve months if the issuer is unable to redeem the bond on its scheduled maturity date. This allows more time to sell the mortgage assets and make the payment without having to accept significant valuation cuts due to a “liquidation sale.”
Most covered bonds in Europe today also benefit from a 180-day liquidity buffer requirement, requiring issuers to reserve sufficient liquid assets to cover interest and repayment payments due over the next 180 days. However, the liquidity available for redemption payments may depend on whether national covered bond legislation requires banks to make such reserves with reference to the expected expected maturity date of the covered bond or with reference to its final maturity date. extended to twelve months.