What Is a Covered Bond?

A covered bond is a package of loans that were issued by banks and then sold to a financial institution for resale. The individual loans that make up the package remain on the books of the banks that issued them, serving as a collateral pool. This adds a layer of security for holders of the covered bonds. It is a type of derivative instrument. Elements of the covered bond may include public sector loans and mortgage loans.

Understanding the 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.

Safety of the 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. 

Their use has grown in recent years. 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 the 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.

Example of a Covered Bond

In July 2016, Fitch ratings confirmed DBS Bank Ltd.’s outstanding mortgage-covered bonds, worth over $1.5 billion, were rated AAA. Bayfront Covered Bonds Pte. Ltd guaranteed the covered bond payments. The high rating was partly due to DBS Bank’s long-term issuer default rating of AA-, a stable discontinuity cap of three notches, and the asset percentage used in the asset coverage test of 85.5%.

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.