What is a Covered Bond and Are They Safe?

The federal goverment supports the idea, but are covered bonds safe?

Financial analysis
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A covered bond is a type of derivative investment that is popular in Europe but fairly rare in the U.S. These bonds are similar to – but generally believed to be much safer than – asset-backed and mortgage-backed securities.

The concept behind covered bonds is simple. The bonds are backed by the cash flows generated from an underlying investment pool. A bank buys a bunch of cash-generating investments, combines them, and issues a bond that is supported by the cash from the investments. That collection of investments, called the “cover pool,” consists of either mortgages or public-sector loans. In that sense, covered bonds create cash flows for investors in exactly the same way that asset-backed securities do.

Are Covered Bonds Safe?

There is one key difference between covered bonds and asset-backed securities, according to bond-investment giant Pimco. "The loans backing a covered bond remain on the balance sheet of the issuing bank." Or, to put it in simple English, if a financial institution that sells a covered bond goes bankrupt, investors in the covered bond retain their access to the “cover pool.” So if you buy a covered bond from the Wall Street BigWig Investment Bank and that bank goes belly up, you're likely to still get your interest-rate payments and get your principal back when the bond matures.

In other words, a covered bond is a standard corporate bond issued by a financial institution but with an extra layer of protection for investors. That extra protection generally results in AAA ratings for covered bonds.

Where Can I Buy a Covered Bond?

The easiest place to buy a covered bond is in Europe, particularly in Germany where the bonds are called Pfandbriefe. Similar bonds can be traced to the 1700s in Germany.

Buying these debt investments closer to home isn’t easy, but things are slowly changing. Two U.S. banks – Bank of America and Washington Mutual – issued covered bonds in 2006, but the credit crisis hit before the market could grow and the idea of a new form of asset-backed security wasn’t particularly popular with traders or investors. Then U.S. Treasury Secretary Henry Paulson voiced support for the investment vehicles in early 2008, and on July 15, 2008, the Federal Deposit Insurance Corp. (FDIC) issued guidelines on how covered bonds would be paid in the event of a bank failure.

But covered bonds still were not considered a thriving investment five years later in 2013, and we can only wait to see how – and if – a new presidential administration will affect them beginning in 2017. 

Should You Buy a Covered Bond?

Just like with other derivative products such as mortgage-backed securities and credit default swaps, complexity and minimum-investment requirements will limit access to the covered bond market to institutional and high-net-worth investors. And that’s probably a good thing. Longtime market watchers will note that we’ve been down this road before and we’ve seen that a complex investment created by the most brilliant folks on Wall Street isn’t necessarily a safe investment because the smartest guys in the room are often pretty dumb.