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Covered bonds are a type of debt instrument that is issued by a bank. These types of securities have two main features, which are: the issuer has pledged its assets to back up payments on the bond, and investors can buy these bonds at lower yields than other comparable instruments because they get paid if there’s an issue with the borrower.
In this article, we are going to take a look at what covered bonds are and how they actually work.
Definition of Covered Bonds
Covered bonds are generally characterized as being long-term debt securities that are issued by banks. They can be either secured or unsecured, and they pay out interest over time with the goal of helping to provide liquidity for issuing banks.
Overall, covered bonds are perfect for spreading risk between investors and issuers, because the former will receive their income as long as the issuer hasn’t defaulted or failed to pay. This helps reduce the risk for both parties.
Benefits of Covered Bonds
There are a number of benefits that covered bonds offer to both investors and issuers. For example, these types of securities are considered relatively safe when compared to other types of debt instruments like mortgages or loans. This is because they can’t be traded on the secondary market. And in case there’s an issue with the borrower, then investors will get their payments.
The risk management goals of covered bonds are also a good thing for investors. And these can even help to lower the cost of funds and raise capital for a bank or other financing institution that issues them. In short, covered bonds provide borrowers with cheaper funding sources that can be used to make new loans or otherwise improve liquidity in the market.
As said above, covered bonds are considered a safe investment because they have more collateral backing them up than other types of debt instruments. In this respect, the European Investment Bank (EIB) has mostly financed covered bond banking projects throughout Eurozone countries.
How do Covered Bonds Work?
Covered bonds work in a very similar way to how normal corporate bonds work. However, unlike standard bonds that can be freely traded on the secondary market, covered are only eligible for redemption from the issuing bank at the maturity date of these instruments. This is only possible if investors have actually been paid their interest and received principal payments (if due).
The main difference between covered and normal bonds is that the former have assets under them as collateral. This provides investors with a greater level of security in case there’s a payment issue. And this also helps to bring down the cost of funds for issuing banks.
So as you can tell, there are a lot of advantages to both investors and lending institutions. But this doesn’t mean that covered bonds aren’t without their drawbacks. For example, they have a relatively low liquidity level (compared to normal corporate bonds). This is because they can only be sold back to the issuer at the end of their term period.
Conclusion
Overall, covered bonds are great for spreading risk between issuers and investors because the former gives up assets that can be used to back these instruments up in case there’s a payment issue. And this provides investors with a greater safety net than they would normally have with other types of debt instruments.
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