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%.

RELATED TERMS
  1. U.S. Savings Bonds

    A U.S. savings bond is a government bond that offers a fixed ...
  2. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  3. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
  4. Bond Ladder

    A portfolio of fixed-income securities in which each security ...
  5. Bond Resolution

    1. A document used with government bonds, especially general ...
  6. Foreign Bond

    A bond that is issued in a domestic market by a foreign entity, ...
Related Articles
  1. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Financial Advisor

    Advising FAs: Explaining Bonds to a Client

    Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
  3. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  4. Investing

    Find The Right Bond At The Right Time

    Find out which bonds you should be investing in and when you should be buying them.
  5. Investing

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  6. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  7. Investing

    U.S. Corporate Bonds: The Last Safe Place to Make Money

    There aren't many other sources right now for relatively safe, steady income.
  8. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  9. Investing

    Surprise! The Best Long-term Bond Investment May Be Savings Bonds

    A 20-year Series EE savings bond pays more interest than a 20-year Treasury bond. So are government-issued long-term bonds the best bet going?
RELATED FAQS
  1. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
Hot Definitions
  1. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  2. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  3. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  4. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  6. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
Trading Center