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What are covered bonds?

Over the past few months I have heard about covered bonds and now the Gillard Government wants to allow our financial institutions to issue them. What are they and are they safe?

Covered bonds are securities created from either mortgage loans or public sector loans and make up one of the oldest and largest sectors of the European bond market. They tend to be good yielding and are high on the safety rating scale. Imagine a bank put together a pool of A-grade, low risk mortgages and then used this as backing behind a bond raising. This would be a covered bond. They can be backed by high-quality mortgage loans or by public sector loans. If the issuing bank should go belly up, then the assets in the cover pool are separated from the issuer’s other assets solely for the benefit of the covered bondholders. This makes the covered bond less liable to be infected by other silly decisions made by the issuing bank.

Covered bonds are usually rated around triple or double A and that makes them attractive and I reckon a lot of retired investors and super funds could look at covered bonds in the future.

A part of the relative safety of covered bonds is that the loans backing a covered bond remain on the balance sheet of the issuing bank. The bonds are therefore obligations of the issuing bank, and the issuer retains control over the assets.

Laws on covered bonds vary slightly, country to country, and so we will have to see the fine print on our future covered bonds, but I think it’s a good innovation to help funding to local banks.

In summary, the credit quality is good with covered bonds, the yield is better than government bonds, it provides variety for conservative investors and there’s full recourse to the underlying assets with the covered bond. And if the bond-issuing bank failed to make payments on a bond, interest payments from the underlying mortgages would go to investors.

A property collapse and recession could make for some emotional moments but these bonds would have a lot more resilience than other competing investment assets.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Friday, December 17, 2010

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