Definition
A covered bond is a type of security that is backed by cash flows from mortgages or public sector loans. Unlike asset-backed securities, the originators of covered bonds maintain the underlying assets on their balance sheet. If the originator defaults, the bondholders have a claim against both the collateral for the bond and the originating institution.
Key Takeaways
- Covered bonds are debt securities issued by a bank or financial institution. The key aspect that differentiates covered bonds from other bond variations is that they are backed by a specific pool of high-quality assets that remain on the issuer’s balance sheet.
- The asset pool providing backup is typically comprised of mortgages or public sector loans. In the case of issuer’s insolvency, these assets can be relied upon for repayment which makes covered bonds typically safer investments, providing additional protection to bond holders.
- Interest on covered bonds is usually higher than on government bonds due to their riskier nature, but lower than on unsecured bonds from the same issuer. This characteristic makes them an attractive investment option that strikes a balance between risk and return.
Importance
A covered bond is essential in finance as it presents a relatively low-risk investment alternative due to its dual-recourse structure.
When investors buy a covered bond, they have a claim against both the issuing financial institution and a separate pool of assets, or cover pool, that collateralizes the bond.
Thus, in the event of the issuer’s bankruptcy, the bondholder maintains a priority claim to the cover pool.
This reduced risk often leads to a lower yield compared to other bonds but provides the issuer with a cost-effective way to raise capital while potentially improving its credit rating.
Covered bonds, common in European financial markets, are an important tool for diversifying funding sources and managing risk.
Explanation
Covered bonds serve an important purpose in financial markets as they help banks raise funding. They act as a method through which banks or mortgage institutions can access capital by issuing bonds backed by the cash flows from their assets, usually mortgages or public sector loans.
The term “covered” refers to the additional security provided by the pool of assets, giving the bondholders extra comfort that even in the event of issuer’s default, they have a claim to these assets. The use of covered bonds allows banks to gain more flexibility in their funding and to diversify their borrowing base.
It’s an efficient tool that, even under circumstances of financial instability, can reduce risks and help maintain the flow of credit. Moreover, covered bonds appeal to investors because they usually offer better returns compared to government bonds, while still offering a relatively low risk profile.
This can make them attractive during periods of economic uncertainty or market volatility.
Examples of Covered Bond
European Covered Bonds: These are among the oldest and most popular covered bonds in the financial world. They were first introduced in the 18th century in Prussia. The German Pfandbrief, a typical European covered bond, is backed by real estate mortgages or public sector loans. Its legal frameworks ensure that in the event of default from the issuer, bond holders still have claims on the assets.
Canada’s Covered Bond Programme: The Royal Bank of Canada issued its first covered bond in
These bonds are backed by assets such as residential mortgage loans. The Canadian government provides a legal framework for covered bond issuance, which ensures dual recourse for investors. If the bank were to default, investors could claim the underlying assets.
US Covered Bonds: Though not as popular or well-established as in Europe or Canada, the US does have a history of issuing covered bonds. For example, in 2006, Washington Mutual (now JPMorgan Chase) was the first US bank to issue a covered bond. They are typically backed by residential mortgages, commercial mortgages, or public debt. US covered bonds have not fully developed, in part due to a lack of a specific legal framework that offers the same level of protection to investors as in Europe or Canada. In each of these cases, a covered bond is a debt instrument secured by a pool of assets that remains on the issuer’s balance sheet. Should the bond issuer default, bond holders have a claim not only on the proceeds from the cover pool but also the issuer, providing extra security to bond holders.
Frequently Asked Questions about Covered Bond
What is a Covered Bond?
A Covered Bond is a security issued by a financial institution, typically a bank, that is backed by a separate group of loans also originated by the financial institution. The investor has recourse to both the underlying collateral of the bond and the issuing institution, which offers greater security.
How does a Covered Bond work?
The issuer of a covered bond pays periodic interest payments to the bondholder and repays the principle of the loan on the specified maturity date of the bond. If the issuer is unable to make these payments, the bond is backed up by a pool of assets, typically high-quality residential mortgages or public sector loans.
What is the difference between a Covered Bond and other types of bonds?
A Covered Bond is unique because it gives the bondholder a claim on a separate pool of assets if the issuer is unable to meet payments. This differs from other types of bonds where the bondholder only has a claim on the issuer. As such, covered bonds are considered to be lower risk than other types of bonds.
What are the benefits of investing in Covered Bonds?
Covered Bonds offer a high level of security and a predictable income stream, making them an attractive investment. Also, due to their dual recourse structure, covered bonds typically have high ratings and a lower risk premium than comparable unsecured debt.
Related Entrepreneurship Terms
- Collateral: This refers to the assets that grant a security interest to the investor in a covered bond.
- Issuer: This refers to the institution, usually a bank, that issues the covered bond.
- Dual Recourse: This is a key feature of covered bonds, providing a safety buffer for investors as they have claims on both the issuing bank and the underlying collateral.
- Maturity: This refers to the period of time the covered bond is expected to be paid back by the issuer.
- Cover Pool: This includes assets that the issuer has specifically set aside to secure payments to covered bondholders, should the issuer default.
Sources for More Information
- Investopedia – It is a reliable source of information for all finance-related terminologies including Covered Bonds.
- The Balance – The website provides expertly written content on personal finance and money management which includes valuable information about Covered Bonds.
- Corporate Finance Institute – It offers courses and resources in finance and can provide a deep understanding of Covered Bonds.
- Financial Times – A renowned financial news portal that includes articles and blogs discussing different finance concepts like Covered Bonds.
