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Covered Bonds

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Definition:

Covered bonds are a type of asset backed security that is common in Europe, but only recently starting to appear in U.S. securities markets. Unlike the typical CMO found in U.S. markets, the assets behind covered bonds, usually mortgages, remain on the books of the issuing bank. Accordingly, if these mortgage loans go bad, the issuing bank retains responsibility for making payments to holders of the covered bonds.

A potential concern among U.S. investors is that covered bonds may be severely impaired in value, if not worthless, if the issuing bank becomes insolvent and regulators abrogate the linkage between those loans and the bonds. As of April 2010, Congress was considering legislation to clear up this matter.

From the standpoint of issuing banks, covered bonds are less attractive than traditional MBS precisely because they do not remove loans from the balance sheet, and because they leave the bank exposed to the risk that the borrowers do not repay on schedule. Nonetheless, U.S. and Canadian banks have been making several forays into this market since 2006.

See "RBC Tries a European Import," The Wall Street Journal, 4/7/2010.

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