Covered Bonds in Bulgaria: Low Risk with Huge Potential

What are covered bonds and are they a novelty for the Bulgarian market?

Covered bonds are debt securities issued by a credit institution (bank) and secured by assets that meet certain requirements and serve to satisfy investors in their capacity as preferred creditors.

Their origin is associated with King Frederick II of Prussia, who introduced covered bonds in 1769. Over the years, these instruments have established themselves as an important source of cheap and long-term financing for banks, as well as highly secure and reliable investment instruments, ranked by credit rating next to or close to that of government bonds.

In Bulgaria, the Mortgage Bonds Act (“MBA”) has been in force since 2000, introducing into the Bulgarian legal system a characteristic type of covered bonds, namely those secured by mortgage loan receivables. The data show that in 20 years only 29 issues have been issued with a total value of EUR 270 million, which is an insignificant share of banks' assets and comes to show the Bulgarian covered bond market is almost inactive.

The Draft Act on Covered Bonds

On December 7, 2021, the Council of Ministers submitted to the National Assembly a Draft Act on Covered Bonds, which has the ambitious goal of introducing a comprehensive legal framework for this financial instrument in the Bulgarian national legislation. Among the envisaged changes are the abolition of the current MBA and the harmonisation of the national legislation with the European one through the transposition of Directive (EU) 2019/2162 on the issue of covered bonds and covered bond public supervision (Covered Bonds Directive).

The proposed legislation is a significant step towards upgrading and developing these instruments. The key takeaways of the Draft Act are:   

1. The range of assets that can serve as collateral for issued bonds is expanded and detailed requirements are introduced regarding the coverage pool and the assets included in it. In so far as only mortgage loans have been able to serve as collateral in Bulgaria for the last 20 years, this is one of the reasons, along with the highly liquid banking sector, which limit the use of covered bonds as a financing instrument. The proposed changes to the eligible assets will include:

► exposures to or guaranteed by central governments, central banks of the European System of Central Banks, public sector entities, regional governments or local authorities in the Union;

► exposures to or guaranteed by central governments of third countries, central banks of third countries;

► loans secured by mortgage or pledge on ships, etc.

The coverage pool also includes derivative contracts for the purpose of hedging risks. Bulgarian banks will be able to participate in intra-group structures for issuing covered bonds and in co-financing the issue of covered bonds by two or more banks.   

2. A supervisory framework for issuers and covered bond issuance programs is being established, which is absent in the existing MBA. The proposed Draft Act defines the Bulgarian National Bank as the competent supervisory body and formulates its powers. Targeted public supervision is a guarantee to protect the interests of investors and plays an essential role in the high quality of the instrument and the assets that secure it.   

3. The figure of a cover pool monitor is introduced, who can be appointed by the issuing bank to exercise independent control over the management of issued programs or issues of covered bonds. The purpose of this figure is to contribute to increasing the attractiveness of larger issues of covered bonds issued by Bulgarian banks among foreign and local institutional investors, including by making it possible for such bonds to receive an appropriate rating.   

4. The figure of a special administrator of covered bonds is also envisaged, which functionally replaces the trustee within the meaning of Art. 20, para. 1 of the MBA. The special administrator is responsible for taking care of the interests of investors in case of insolvency of the issuer or its restructuring, thus harmonising our national legislation with the good legislative practices of countries with developed covered bond markets.   

5. The method of separating the assets from the coverage from the remaining assets of the issuing bank (on balance sheet) is preserved, as in is so far in the MBA and the concept of “double claim” is confirmed - when the coverage pool is not enough to satisfy the bondholders, they retain their claim against the bank and have the status of chirographic creditors in the insolvency proceedings   

6. The legal regulation also includes the requirements for a minimum level of oversecurity of the issues of covered bonds and for a liquidity buffer of the set of collaterals.

Prospects for covered bonds

The adoption of a law on covered bonds in line with the European legal framework will inevitably have a beneficial effect on the untapped potential of capital markets in the European Union, contributing to diversifying the circle of investors, stimulating investment in the EU and attracting more investors from third countries. At the national level, covered bonds can be the necessary efficient tool for financing and further developing the mortgage market, as well as reducing costs for both banks and borrowers.

A new class of covered bonds – "green covered bonds" – also responds to the growing investor interest and the directing of free funds in green investments. Their purpose is to use the proceeds from the issued issues to finance or refinance various green projects to promote the reduction of the impact of human activities on the environment. The introduction of the new legislation will open additional opportunities for promoting green investments among Bulgarian issuers and investors.