Covered bonds are not a new invention, but they are still very relevant today. We explain what covered bonds are, who uses them, how they work as an investment instrument and what’s behind them.
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Covered bonds date back to the Middle Ages. At that time, individuals or cities who took out covered bonds would pledge assets as collateral in exchange for credit. In the German-speaking world, the certificate that was issued for this was called a Pfandbrief (“pledge letter”).
In Switzerland today, covered bonds are an instrument for banks to acquire long-term capital to finance their mortgage lending. That is to say, banks refinance the mortgage loans they issue via covered bonds. Since 1930, Switzerland’s Mortgage Bond Act has provided a strict regulatory framework for issuing covered bonds. Accordingly, only two institutions in Switzerland have the right to issue covered bonds, namely the Central Mortgage Bond Institution of Swiss Cantonal Banks and the Mortgage Bond Bank of Swiss Mortgage Institutions. These mortgage bond institutions loan money to banks, on the condition that the banks use that money solely to grant mortgages to their customers. Covered bonds are issued as fixed-interest securities on which a fixed interest rate is applied for a specified duration. They may be traded on the stock exchange.
Since the issuing and coverage of covered bonds are bound by strict legal rules and backed by tangible assets (usually property), they are considered particularly secure financial investments. National legislation on covered bonds varies greatly from one country to the next.
In Switzerland, covered bonds are secured at multiple levels. Firstly, they are collateralized by the issuing mortgage bond institution against its own assets. If the institution becomes insolvent, the bonds are covered by the commercial banks that issued the mortgages. If these institutions also collapse, the mortgage debtor has to step in − ultimately, the private or commercial property serves as collateral.
Covered bonds are collateralized securities. This type of bond is covered by collateral, which is what gives them the name “covered bonds”.
