WSJ: What Are Covered Bonds

Is there a path to higher yield and lower risk in the bond market? Apparently there is, if you believe the promises of so-called covered bonds.

These are a type of mortgage security, issued mainly by financial institutions in Europe, that offers fixed-income investors a double layer of protection against default.

Covered bonds differ from typical mortgage-backed securities in the U.S. in that the issuing bank retains ownership of the underlying mortgages. "The fact that it's on [the] balance sheet means that the issuer has skin in the game," says Kristion Mierau, a portfolio manager and covered-bond expert at Pacific Investment Management Co., or Pimco.

During the real-estate boom last decade, U.S. banks had little incentive to ensure that the mortgages they were packaging into securities were of high quality. After all, their future wasn't tied to the performance of the bonds.

But ownership is just one part of the story. There's a bigger piece. If the bank itself goes bankrupt, covered-bond holders are first in line to claim the mortgages backing their bonds. "If the bank goes bust, that doesn't necessarily mean that the covered-bond program goes bust," says Mr. Mierau.

Covered-bond yields depend on the country of origin and the issuing bank, but they are typically higher than government bonds. In Germany, for example, covered bonds pay 1.3% to 1.7%, according to Pimco. That compares with rates of about an eighth of 1% on two-year German bunds.

If you buy mutual funds that invest globally you may find you own covered bonds. That's much less likely with domestically focused funds since covered bonds are issued mainly by European banks.

Now, however, retail investors, can buy covered bonds through the newly created ProShares USD Covered Bond exchange-traded fund. So far the fund has attracted little interest.

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