Pricing Covered Bonds

Abstract

Covered bonds have emerged as a potential funding vehicle from the credit crisis. However, there is no detailed examination of how covered bonds should be priced taking into account the features that make them attractive to investors: i.e. over-collateralization of the reference pool and covenants by the pool manager (issuer) on asset replacement. Assets may be replaced because, for example, they have been downgraded. In as much as asset replacement is costly, replacement uses up liquidity from the issuer of the covered bonds. This study provides the first pricing method for covered bonds and is based on a Triggered Refreshed CDO model that we introduce here.

A Refreshed CDO is one where the first m assets that default are replaced. A Triggered Refreshed CDO is one where replacement is triggered by a credit event other than default, e.g. downgrade, restructuring, etc. Thus the first m defaults (or other replacement-causing events) do not affect the coverpool of n assets. Only subsequent actual defaults matter to the coverpool. m expresses the liquidity available from the issuer to replace assets. A further step is to include issuer default not caused by the coverpool directly. We define this as a Triggered Refreshed CDO with Issuer Risk.

We provide analytic pricing for Triggered Refreshed CDOs with or without Issuer Risk, i.e. covered bonds, based on the factor Copula model. These formulae are general in that they apply to any Copula model. We give an efficient simulation algorithm as an alternative pricing method. We analyze a hypothetical coverpool at the entity concentration level (e.g. cities, Lander, public sector entities), and its covered bond prices. We provide example results for a variety of scenarios showing the interplay between covenants, issuer risk, and liquidity.

Keywords: covered bonds, pricing, CDO, factor model, copula, issuer risk

JEL Classification: G12, G13, G21, G33, H74, H84, K22