A covered bond is a type of derivative investment popular in Europe that is relatively rare in the U.S. They are similar to—but generally believed to be much safer than—asset-backed and mortgage-backed securities.
Learn what a covered bond is and what makes them a secure investment.
- Covered bonds are supported by banks with cash from underlying investment pools called “cover pools.”
- Covered bonds are safer and more secure than asset-backed securities because they’re protected in the event that the institution goes bankrupt.
- These bonds aren’t widely available in the U.S., but they’re more common in Europe and particularly in Germany.
What Is a Covered Bond?
The concept behind covered bonds is simple. They are backed by cash generated from an underlying investment pool. A bank buys substantial cash-generating investments, combines them, and issues a bond supported by the pooled investments' money.
That collection of investments, called the cover pool, consists of either mortgages or public-sector loans. In that sense, covered bonds generate cash flow for investors the same way as asset-backed securities.
What Makes a Covered Bond Secure
One key difference between covered bonds and asset-backed securities is that with covered bonds, the loans that back them remain on the balance sheet of the issuing bank. To put it more simply, if an institution selling a covered bond goes bankrupt, investors in the covered bond retain their access to the cover pool.
For example, if you buy a covered bond from a Wall Street Investment Bank which goes belly up, you're still likely to get your interest-rate payments and principal back when the bond matures.
A covered bond is essentially a standard corporate bond issued by a financial institution with an extra layer of protection for investors. The additional protection generally results in AAA ratings for covered bonds.
Where You Can Buy a Secure Covered Bond
The most accessible place to buy a covered bond is in Europe, particularly in Germany on the Frankfurter Wertpapierbörse (FWB)—the Frankfurt Stock Exchange. There, covered bonds are called Pfandbriefe. In Germany, similar bonds can be traced back to the 1700s.
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. The idea of a new form of asset-backed security wasn’t particularly popular with traders or investors after 2007.
U.S. Treasury Secretary Henry Paulson voiced support for the investment vehicles in early 2008. 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. The initial enthusiasm over covered bonds seems to have tapered off, with a substantial decline in bonds issued from 2016-2017, after years of meager investment interest.
Who Can Get Secure Covered Bonds?
Similar to other derivative products such as mortgage-backed securities and credit default swaps, the complexity and minimum-investment requirements limit covered bond access to institutional and high-net-worth investors.
Longtime market watchers know their history and understand a complex investment created by the most brilliant folks on Wall Street isn’t necessarily a safe investment.
Covered bonds are interesting, but until enough legitimate offerings hit the market so that ETFs are created to limit their downside, they need to be scrutinized as much as any other investment vehicle.