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Covered bonds: an option to deepen Nigeria’s capital markets

Banji Adenusi
As debt securities issued by governments, government agencies, and corporations, bonds are an external source of funding for the expansion of an issuer's business (as in the case of corporate bonds), or for the development of infrastructure projects. In recent times, the primary market for corporate bonds in Nigeria has witnessed tremendous growth, as the number of corporate bonds listed on the Nigerian Stock Exchange has risen to a respectable 18 as of January 2013.

While the issuance of government bonds and corporate bonds is regulated by the Nigerian Securities and Exchange Commission (SEC), the incidence of covered bonds is altogether a different proposition, as applicable legislation in this regard is non-existent. The United States Federal Deposit Insurance Corporation describes covered bonds as "general, non-deposit obligation bonds of the issuing bank secured by a pledge of loans that remain on the bank's balance sheet". Essentially, the defining feature of covered bonds is the duality of protection offered to investors, namely: (a) liability of issuer (typically a financial institution) for repayment; and (b) the special pool of collateral, also known as cover pool, on which investors have a preferential claim in the event of the issuer's insolvency. Typically, these collaterals are by way of high-grade mortgages or loans to the public sector or shipping loans. When contrasted with asset-backed securities (ABS), the cover pool becomes credit enhancement leverage, as they are more dynamic in the sense that assets can be added or replaced in the pool over time, especially where the value of these assets diminish or an early repayment has occurred. In addition, the credit risk stays with the issuer, as the borrower continues to absorb the risk of default and prepayment risk of the pool; much unlike ABS where the issuer does not absorb the risk of default beyond the agreed credit support and risk of prepayment is usually transferred to the investor. Herein lies the major difference between covered bonds and securitisation in general.

In recent times, covered bonds have been adapted to finance the residential and commercial real estate markets and have emerged as an important aspect of the fixed-income bond market. Traditionally, covered bonds have mostly been utilised in Europe where they are subject to extensive regulatory supervision for the protection of investors, especially considering the risk of insolvency of the issuing institution. However, just like Canada and the United States, there is no legislative framework for covered bonds in Nigeria. In the absence of legislation, issuers typically resort to structured covered bonds by incorporating features and mechanisms of structured finance.

This is achieved through contractual arrangements involving the incorporation of a special purpose vehicle (SPV), where the assets are held by the SPV which guarantees the bond issued by the originating bank. In other climes, this structured approach is achieved by having a subsidiary of the parent bank issue the bond, which then lends the funds to the parent bank. By having the cover assets reflected on the balance sheet of the parent bank, the bank is able to guarantee its repayment. Thus, in the event of its insolvency, the subsidiary or issuer takes possession of the cover assets and continues to service the bond. These structured issues still avail investors with recourse to the issuer as well as the cover assets.

In view of the shift towards the acceptance of covered bonds as a complement to securitisation (considering the fact that the balance sheets of financial institutions cannot ultimately replace the huge securitisation market), it is important for Nigerian regulators to plan towards the adoption and implementation of standards in regulating the covered bond market, especially with regards to asset-backed funding devices. Current legislations have provided a base anchor for a stable financial system. However, the need for long term and cost effective funding, sourced from different parts of the private-sector capital market remains considerable. Insolvency laws must equally be revised to ensure their creditor-friendliness. Rules or regulations for their issuance must ensure that the security would not be frustrated or compromised by the insolvency of an issuer, as this is a critical factor in the credit rating of covered bonds. It is under this system of transparency that a covered bond market can thrive within the Nigerian capital market.

Banji Adenusi

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