What it means
The word Pfandbrief (singular) literally means a bond secured by a pledge. Banks issue them to raise long-term funds at a lower cost than ordinary unsecured bonds, because investors accept a lower interest rate in exchange for the extra security.
The funds are typically used to finance property loans or public-sector lending. The key feature is dual recourse.
An investor can look first to a ring-fenced cover pool, which is a separate group of assets set aside to repay the bonds, and if that were not enough, to the issuing bank's other assets. The pool remains separate even if the bank becomes insolvent, and a special administrator is appointed to keep paying the holders.
Pfandbriefe are governed by a specific law and supervised by the financial regulator, which sets rules for the quality of loans in the pool, how the assets are valued, and how much extra cover must be held. The pool must contain more assets than the bonds outstanding, a feature called overcollateralisation (holding more collateral than the amount owed).
Regular independent checks help to keep the pool accurate. There are several types, depending on the assets in the pool.
Mortgage Pfandbriefe are backed by loans on property, public-sector Pfandbriefe by loans to governments and public authorities, and there are also ship and aircraft versions. Mortgage and public-sector bonds are by far the best known.
For investors and corporate treasurers, these bonds offer a conservative way to earn a return slightly above government bonds. Their market is large and well established, which makes them easy to trade.
Similar covered bond structures exist in many countries, though the legal details differ. Risks remain, even if they are low.
Property values can fall, interest rates can change the bond's market price, and a country's legal framework can be altered. Credit ratings agencies consider these factors when rating the bonds.
In practice
Real-world examples.
Example
A regional bank wants to fund $500,000,000 of residential mortgages. It issues mortgage Pfandbriefe backed by those loans, paying lower interest than it would on ordinary bonds, which reduces its funding cost. Because the pool is separate from the bank's other assets, funding is stable even when the bank's wider borrowing costs rise.
Example
A pension fund buys Pfandbriefe with $20,000,000 of its bond allocation because it needs safe, predictable income. The fund likes the dual claim on both the pool and the issuing bank. The fund's policy requires the issuer's pool to be independently audited, which gives her comfort about the quality of the collateral.
Example
A corporate treasurer places surplus cash with a short-dated covered bond. She accepts a yield only slightly higher than government debt in exchange for strong protection. She monitors the credit rating of the issuer and the size of the overcollateralisation each quarter.
Formula
Calculation
Overcollateralisation ratio = (value of cover pool - bonds outstanding) / bonds outstanding
Suppose a bank has issued Pfandbriefe with a nominal value of $1,000,000,000 and holds a cover pool of mortgages worth $1,060,000,000. The extra cover is 1,060,000,000 - 1,000,000,000 = $60,000,000. The ratio is 60,000,000 / 1,000,000,000 = 0.06, or 6%. This means the pool could lose about 6% of its value before it fails to cover the bonds, which is a cushion for investors.Case study
Seen in the real world.
Elbe Hypothekenbank is an illustrative, fictional lender that makes long-term property loans. Its funding costs rose when investors became nervous about banks, which squeezed the margin on its mortgages.
The treasurer decided to create a mortgage cover pool of $2,000,000,000 and to issue $1,800,000,000 of covered bonds against it. The overcollateralisation of about 11%, calculated as 200,000,000 divided by 1,800,000,000, gave investors a strong cushion, and the bonds attracted high ratings.
Funding costs fell, and the bank could continue lending even while its unsecured bonds were expensive. The illustrative lesson is that setting aside good assets for investors can lower borrowing costs for the whole bank. The bank also published a regular report on the pool so that investors could see the loan sizes, locations and arrears, which helped the bonds trade at tighter spreads.
Watch out
Common mistakes.
- Treating Pfandbriefe as identical to securitised mortgage bonds, when the loans stay on the issuer's balance sheet and the issuer remains liable.
- Assuming a covered bond has no risk, when interest rate changes and falling collateral values can still affect it.
- Using the word as a singular, when Pfandbriefe is the plural and Pfandbrief is the singular.
Questions
People also ask.
What does dual recourse mean?
Investors can claim on the dedicated cover pool and, if necessary, on the issuing bank's other assets.
Are Pfandbriefe only issued in Germany?
The name and legal framework are German, but covered bonds of a similar kind are issued across Europe and in other regions.
Why do banks issue them?
Because the security they provide allows the bank to borrow for a long period at a lower interest rate.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related