Analyzing the difference in excess returns between senior and covered bond pairs using a factor model approach - An empirical study

Abstract

Covered bonds are investment grade bonds that are backed up by collateral. Senior bonds are unsecured, but have the highest seniority among creditors should the issuer default. Collateral is the main separator of covered bonds and senior bonds. This thesis examines if other factors than collateral have explanatory power for the difference in excess returns between senior bank bonds and covered bank bonds. It also examines the effectiveness of a covered bond collateral proxy in explaining the difference in excess return. A matching method is used to examine the difference in excess return between the two bond types. We use a panel data set with daily and quarterly observations of paired senior bonds and covered bonds. The bonds are issued by a total of 70 different banks. The dataset ranges from January 2007 to January 2012. We find the chosen proxy for covered bond collateral, namely a euro area real estate index, to be insignificant. When we control for the financial crisis, we find four factors not related to collateral to affect the difference in excess return between senior bonds and covered bonds: the stock market risk premium RP, the two bond market factors DEF and T ERM, and the iBoxx index which is a proxy for the bond market risk premium.