What is a 'Covered Bond'

A covered bond is a security created from public sector loans or mortgage loans where the security is backed by a separate group of loans; it typically carries a maturity rate of two to 10 years and enjoys relatively high credit ratings. Covered bonds provide an efficient, lower-cost way for lenders to expand their business rather than issuing unsecured debt instruments. The European Union EU created guidelines for covered bond transactions in 1988 that let investors in the bond market put more of their assets in covered bonds than previously allowed.

BREAKING DOWN 'Covered Bond'

Covered bonds are derivative investments, similar to mortgage-backed and asset-backed securities, that are common in Europe and slowly gaining interest in the United States. A financial institution purchases investments that produce cash, typically mortgages or public sector loans, puts the investments together and issues bonds covered by the cash flowing from the investments. Issuing covered bonds lets financial institutions buy and sell assets to improve credit quality, lower borrowing costs and finance public debt. The institutions may replace defaulted or prepaid loans with performing loans to minimize risk of the underlying assets not performing as well as expected. Investors may put money into safer assets and receive a relatively high return.

Safety of Covered Bonds

The underlying loans of a covered bond stay on the balance sheet of the financial institution issuing the bond. Therefore, 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 the extra layer of protection, covered bonds typically have AAA ratings.

Covered Bonds in the United States

In September 2007, Washington Mutual became the first U.S. bank issuing euro-based covered bonds. Nine months later, Bank of America became the first bank issuing dollar-based covered bonds. JPMorgan Chase, Wells Fargo, Citigroup and other U.S. banks have also issued covered bonds. European banks have expressed interest in entering the U.S. market with euro-based covered bonds.

Benefits of Covered Bonds in the United States

Covered bonds may help U.S. banks raise extra funds for freeing up capital and extending additional mortgages. This stimulates the economy by encouraging consumers to become homeowners. Covered bonds may also provide funding for increasing the development of infrastructure, reducing 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. The covered bond payments were guaranteed by Bayfront Covered Bonds Pte. Ltd. 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%.

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