What Are Covered Bonds, 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, although popular in Europe, is 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 substantial cash-generating investments, combines them, then 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 as asset-backed securities.

Are Covered Bonds Safe?

One key difference between covered bonds and asset-backed securities, according to bond-investment giant Pimco, is that "the loans backing a covered bond remain on the balance sheet of the issuing bank." To put it more simply, if an institution that sells 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 the Wall Street BigWig Investment Bank, which then goes belly up, you're still likely to get your interest-rate payments and your principal back when the bond matures.

A covered bond is essentially 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 on the Frankfurter Wertpapierbörse (FWB)—the Frankfurt Stock Exchange. There, covered bonds are called Pfandbriefe. In Germany, similar bonds can be traced all the way 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, and 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, 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. The initial fervor over covered bonds seems to have tapered off, with a strong decline in bonds issued from 2016-2017, after years of meager investment interest.

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 limit access to the covered bond market to institutional and high-net-worth investors. That’s probably a good thing. Longtime market watchers know their history and understand that a complex investment created by the most brilliant folks on Wall Street isn’t necessarily a safe investment; the smartest guys in the room are often pretty dumb.

Covered bonds are certainly interesting, but until enough legitimate offerings hit the market so that ETFs are created to limit downside, they need to be scrutinized as much as any other investment vehicle.