Weak global economic growth, coupled with fears of a recession in the eurozone, is expected to keep interest rates for the time being artificially low. Therefore the expected real return on a defensive fixed income investment is likely to be negative.
Under these conditions, what are fixed income investors supposed to do? Faced with a difficult choice between accepting low yields, and the increased tail risk surrounding the banking system and the debt spiral, the need to find alternatives to this asset class becomes imperative.
So what alternative is given? Covered bonds can be part of the solution as they provide an attractive spread over government bond yields and additional security relative to unsecured bank debt.
For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer’s financial book, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer book.
Basically a bank buys a bunch of cash-generating investments, combines them, and issues a bond that is supported by the cash from the investments. 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.
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. Given the credit enhancements generally offered by the presence of a cover pool, covered bonds are considered to be some of the safest fixed income securities available. Indeed, the covered bond structure offers a considerably lower risk profile than asset backed securities.
From the issuer’s perspective, the purpose of issuing covered bonds is basically to use a pool of high quality assets in order to achieve cheaper funding. For investors, the appeal of covered bonds lies in their security and the pick-up in yields over government bonds. Searching for covered bonds in this environment may be a strong option to consider.