Finance - Theses

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Liquidity of German covered bonds before and during the financial crisis

Liu, Cheng ( 2015)

Following the 2008 financial crisis, covered bonds (bank-issued debt instruments with credit enhancements such as dual-recourse and dynamic cover pool) have been discussed as an alternative to mortgage-backed-securities (MBS) because of their potential of adding stability to the banking system. While being liquid is a key feature of the MBS market, the liquidity of covered bonds remains less well-understood by investors and academics. To better understand covered bonds, this project measures the liquidity of German covered bonds using transactional data and several common proxies. Results show that German covered bond liquidity is resilient: German covered bonds became less liquid after the Lehman Brothers default and recovered to the pre-crisis level in only one year. Surprisingly, jumbo covered bonds (a conventionally more liquid covered bond market) have lost their liquidity advantage since the onset of the fi nancial crisis. Furthermore, although the covered bond market remained relatively liquid after the Lehman shock, the illiquidity risk premium has become larger post-Lehman compared to pre-Lehman, implying that investors require a higher compensation for holding illiquid covered bonds. The result of this study may have implications for countries that are new to covered bonds to emphasize on managing the liquidity of this market.