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What Is a Covered Bond?
A covered bond is a derivative instrument consisting of a package of loans that banks issue and sell to financial institutions for resale to investors. The individual loans that make up the package are collateralized against assets in case the issuer fails, which adds a layer of security for the holders of the covered bonds.
Elements of the covered bond may include public sector loans and mortgage loans.
Key Takeaways
- A covered bond is a type of derivative instrument made up of packages of loans issued by banks that are sold to investors.
- The loans are collateralized against a pool of assets in case the issuer fails, providing a level of security to the bondholders.
- Banks issue covered bonds in order to free up their balance sheets so they can sell more loans, which helps spur the economy.
Understanding a Covered Bond
Covered bonds are a more cost-effective way for lending institutions to expand their businesses than issuing unsecured debt instruments. They are derivative investments, similar to mortgage-backed and asset-backed securities (ABS).
A bank sells a number of investments that produce cash, typically mortgages or public sector loans, to a financial institution. That institution then assembles the investments into packages and issues them as bonds.
The interest paid on the bonds is covered by the cash flowing from the loans. The institutions may replace defaulted or prepaid loans with performing loans to minimize the risk of the underlying assets.
Covered bonds are common in Europe and are slowly gaining interest in the U.S.
Bond Ratings
Covered bonds are rated by the major bond ratings agencies.
Safety of a Covered Bond
The underlying loans of a covered bond stay on the balance sheet of the issuer.
Therefore, even if the institution becomes insolvent, investors holding the bonds may still receive their scheduled interest payments from the underlying assets of the bonds, as well as the principal at the bond’s maturity.
Because of this extra layer of protection, covered bonds typically have AAA ratings.
Covered Bond Trends
In 1988, the European Union (EU) created guidelines for covered bond transactions that allowed bond market investors to put more of their assets in them than was previously allowed.
The European Bank for Reconstruction and Development has used them extensively to help Eastern European nations strengthen and modernize their capital markets.
U.S. Treasury Secretary Henry Paulson announced on July 28, 2008, that the Treasury and partner institutions planned to rev up the market for these securities in the U.S. Bank of America became the first bank to issue dollar-based covered bonds. JPMorgan Chase, Wells Fargo, Citigroup, and other U.S. banks also began to issue covered bonds.
Benefits of a Covered Bond
Banks use covered bonds to free up cash for other financial activities, such as extending more mortgages to their customers. That activity stimulates the economy by encouraging consumers to become homeowners.
Covered bonds may also free up funds for increasing the development of infrastructure, reducing the financial strain on local, state, and federal government agencies.
Are Covered Bonds a Safe Investment?
Covered bonds are considered a safe investment. Purchased primarily by conservative investors and institutions, they offer an additional layer of protection, meaning that the interest payments and the principal of the bonds could remain intact even if the institution that owns the loans underlying the bonds goes bankrupt.
How Long Have Covered Bonds Been Around?
Some sources suggest that covered bonds have been in existence since the reign of Friedrich the Great, who used covered bonds to finance the reconstruction of Prussia after the Seven Years' War (1756-1763).
The modern covered bond market evolved rather more recently. They gained popularity in Europe in the 1990s, with their introduction in the U.S. dating to 2007.
What Is the Difference Between a Covered Bond and Any Other Bond?
Bonds are secured by the assets of their issuers. In the event of a default, the bond owner has recourse against the issuer. In the case of investment-quality bonds, the default risk is slight.
Covered bonds have two sources of recourse: the first against the issuer of the bond and the second against the assets of the bank that issued the loans that comprise the bond.
The Bottom Line
Covered bonds exist in the usually-risky world of derivatives investments. However, they are among the least risky of investments. They offer the conservative investor a dual layer of protection from loss.