Covered Bond - Detailed Explanation

Detailed Explanation

A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. Before the outbreak of the Financial Crisis in 2008, this enhancement typically (although not always) resulted in the bonds being assigned AAA credit ratings. Due to the realization that many of the loans backing these bonds were of a low quality, credit ratings declined sharply. This diminished the demand for all the types of asset backed or covered bonds, contributing to The Financial Crisis.

For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, 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.

Another advantage is that the interest is paid from an identifiable source of projected cash flow versus out of other financing operations. Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.