What are covered bonds?

A covered bondis a debt instrument issued by a financial institution, which is backed by a basket of assets. It is a more popular type of investment in Europe than in the United States. Although covered bonds are similar to mortgage-backed assets (MBS), they are considered safer.

The concept is simple. They are issues of credit institutions that are backed by other assets. In Spain generally these other assets are mostly mortgage loans, although they can also be loans to public entities. The reason they are considered safer is because they offer a double guarantee for the investor, which makes them very attractive in difficult economic and market stages. The investor of a covered bond has the peculiarity of a double resource for its collection: a credit right on the entity issuing the bonds and another on the basket of assets that make up the coverage.

The first remedy of protection for covered bonds is the full claim of the issuer's assets, so that, in the event of insolvency, investors are protected by a creditor right over the issuer's assets. The second remedy is their preferential access to all the assets of the guarantee. In addition to their superior collateral, covered bonds are also backed by the cash flows of the underlying assets. These cash flows could eventually be used to service the debt, in the event of the insolvency of the issuer, and thus meet the payment of coupons and principal on time, if the issuer is unable to meet its obligations.

Covered bonds have acquired a preferential status thanks to the new measures introduced by the regulatory body of the European Union (EU), as they have benefited from the new applications of the regulatory frameworks of banks and insurance companies. In addition to being one of the most senior debt instruments on the balance sheets of financial institutions, the exception of the EU bail-in mechanism that applies to these bonds, incorporates an additional level of investor protection.

Under the Bank Recovery and Resolution Directive (BRRD), the adjudicating authority can intervene and restructure a bank if it considers that it is in a situation close to insolvency. Since covered bonds do not have to absorb losses through this bail-in mechanism, they are not repaid in the process, unlike senior debt and other types of debt with less collateral.

Covered bonds have not defaulted in their more than 200-year history, while "typically safe" bonds have taken investors by surprise, as evidenced by the case a decade ago, when Greece's sovereign debt, unlike covered bonds, posted losses; or as happened with the senior debt creditors of Banco Espiritu Santo, which suffered large losses in 2016 due to the application of the bank's bail-in mechanism.

Covered bonds are an attractive, low-risk solution for investors for market environments such as the current one. Due to its special characteristics, however, it can be accessed through institutional portfolios, such as investment funds or pension plans, managed by an expert who has the experience and knowledge of the market, as well as information related to the regulation, of covered bonds. The investor thus has the opportunity to access a quality investment capable of offering attractive returns.