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What is a Covered Bond? Looking at the Newest Investment in U.S. Bond Markets

The federal goverment supports the idea, but are covered bonds safe?

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A covered bond is a type of derivative investment that is popular in Europe, but fairly rare in the U.S. market. The 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 cashflows generated from an underlying investment pool. A bank buys a bunch of cash-generating investments, combines them, and 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 cashflows for investors in exactly the same way that asset-backed securities do.

Are Covered Bonds Safe?

But there is one key difference, according to bond-investment giant Pimco, "the loans backing a covered bond remain on the balance sheet of the issuing bank." Or, to put it in simple English, if a financial institution that sells a covered bond goes bankrupt, investors in the covered bond retain their access to the “cover pool.”

So if I buy a covered bond from the Wall Street BigWig Investment Bank, and that bank goes belly up, I’m likely to still get my interest-rate payments in the mail and get my principal back when the bond matures.

A covered bond, in other words, is 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, where the bonds are called Pfandbriefe. Similar bonds can be traced to the 1700s in Germany.

Buying these debt investments closer to home isn’t easy. But things are changing rapidly.

In 2006, two U.S. banks – Bank of America and Washington Mutual – issued covered bonds. But before the market could grow, the credit crisis hit, and the idea of a new form of asset-backed security wasn’t particularly popular with traders or investors.

But early 2008, U.S. Treasury Secretary Henry Paulson voiced support for the investment vehicles. 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.

Should I Buy a Covered Bond?

Paulson’s comments and the FDIC’s actions are likely to accelerate the development of the covered-bond market in the U.S. But just like with other derivative products such as mortgage-backed securities and credit default swaps, complexity and minimum-investment requirements will limit access to the covered bond market to institutional and high-net-worth investors.

And that’s probably a good thing. Longtime market watchers will note that we’ve been down this road before. And we’ve seen that a complex investment created by the most brilliant folks on Wall Street isn’t necessarily a safe investment. Because the smartest guys in the room are often pretty dumb.

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