Covered Bonds

Covered Bonds: A type of derivative instrument, normally issued by a financial institution, that are collateralised by an underlying pool of investments. It can be seen as a conventional corporate bond with added collateral protection for the investors.

This generally implies a AAA credit rating is applicable to the issue.

Trading Covered Bonds

The “cover pool” is the portfolio of loans or mortgages that generates the cash flows that pay out to investors in the bonds.

They thus create the same sort of investment profile as that of asset backed securities, but with one major difference- the underlying loans etc. remain on the financial institution’s balance sheet, meaning that should the bank enter bankruptcy, investors retain their access to the cash flows of the underlying investments.

If the bond is uncovered, the investor is reliant on the firm’s financial viability for their continued payments, as those assets have often been sold to a third party.

Their issuance allows firms to free up capital for other activities (e.g. new mortgage issuance) or facilitates the reduction of debts in local or state entities and are a more cost-effective method of financing that issuing non-secured debt.

They are still popular in Europe (in Germany they are called Pfanbriefe), but are not so common in the US, where interest in the products was stifled by the Mortgage Crisis of 2007-09 and they have not seen any significant pickup thereafter.

In the UK, issuance is primarily by mortgage firms, such as Nationwide, Santander and TSB. Although they are quoted on the LSE, they do not attract a great deal of liquidity and are thus hard to trade.