Covered bonds are bound to become more desirable.
The European Parliament has made a sound proposal to lower the risk weightings of both high quality covered bonds and the best Simple, Transparent and Standardised (STS) securitization tranches to 5%.
Both covered bonds and top securitization tranches are overcollateralised and highly rated.
Covered bond fans claim they are superior because they have dual recourse to the bank issuer and to the asset pool in case of a bankruptcy.
Securitization supporters argue their product is best because it offers full remoteness from a bankruptcy of the issuer through a true sale of the collateral.
Covered bonds have a longer track record — no defaults in the 250 years of the market’s existence.
Admittedly, past performance is no guarantee of future results.
Covered bonds are also more widely known in Europe and have been growing internationally among investors and issuers.
Some argue they are also easier to understand.
But is not about which instrument is better or worse. It is more important to treat them both on an equal footing, to avoid distorting the market.
This is especially true when European regulators and politicians are eager to lubricate capital flows to key sectors such as residential property and public infrastructure, and even to improve the flagging commercial real estate market.
Covered bonds have formed the backbone of such financing for decades. They must not be treated as inferior to STS securitization.
The European Union's legislators — the Commission, Council and Parliament — should adopt the Parliament's proposal and bring the two asset classes on par.
This would further Europe's quest for growth, by not indirectly weakening covered bonds as a stable funding channel for banks and impairing their investor base.
A big wave of covered bonds is coming up for refinancing in 2026 and 2027 — a technical negative factor.
But most European covered bonds have the right credit ratings to qualify for the risk weighting reduction, and this will enhance their appeal to bank treasury investors. That should result in spread tightening.
Some bankers have suggested it might begin as soon as January's issuance unfolds, while others expect visible tightening only once there is a political nod towards implementing the lower risk weights.
Regardless of the timing, covered bonds have been a formidable asset class that has shown strength through stormy days, outperforming government bonds. As the most recent example, France's political jitters have pushed the country's covered bonds to trade inside OATs in longer tenors.
This only hints at what could come when sovereign and agency borrowers ramp up their issuance, driving up govvie yields despite interest rate cuts by central banks.
A risk weighting blessing will further enhance the appeal of covered bonds.