Although the U.S. is renowned for financial innovations, it is far behind Europe when it comes to the covered bond market, an efficient and almost risk free financial instrument that originated in Prussia in 1769 and is still widely used in Europe and Canada. Nevertheless, a covered bond ETF is coming soon to the public in the U.S.
Covered bonds have actually been available in the U.S. for some time, and according to Dealogic, $25 Billion has been sold this year, and $39.9 Billion in 2011. The reason that covered bonds have been scantily mentioned by the press or noticed by retail investors is due to the fact that, up to now, they are sold in private placements under Rule 144A, which restricts who can buy or sell covered bonds.
Covered bonds are basically corporate bonds with an added layer of security and generally are the realm of financial institutions. The bonds are covered by an underlying pool of assets that can be tapped in case of default, thereby resulting in investors having recourse to the pool and the issuing institution at the same time and most often garnering AAA ratings from Fitch Ratings, Standard & Poor’s rating Group, and Moody’s Investor Services.
The cover pool of assets typically consists of mortgages and public sector obligations and remains on the balance sheet of the issuer. Moreover, issuers have to ensure that the covered bonds are consistently backed by the cover pool, with non performing or prepaid loans to be replaced by newer assets that conform to the requirements.
Another cited advantage of covered bonds is that the interest paid comes from a specific source and not out of the issuer’s general funds, therefore not easily manipulated by the issuer.
With all of these factors coming into play, a covered bond ETF can easily replace money market funds, or even CDs where liquidity can become an issue.
In 2008, Henry Paulson, U.S. Treasury Secretary at the time, suggested covered bonds as an alternative to toxic mortgage backed securities, and the Federal Reserve did its part by announcing that covered bonds will be considered as acceptable collateral in the request for emergency funds, signaling acceptance of the notion that covered bonds are presumed to be almost risk free.
Coming at no surprise, covered bonds managed to retain their high desirability and the covered bond market is the first one to recover during the turbulence of the present economic crisis. Indeed, if the covered bond market starts to expand rapidly and provide a new source of liquidity to U.S. financial institutions, thereby bypassing government bailouts, this market has the potential to spread across the globe and stabilize global banking institutions, as well as provide retail investors with a decent return and peace of mind.
To tap into the U.S. market, ProShares has just launched a new fund, under the name of ProShares USD Covered Bond ETF (COBO), with .35% as the annual expense ratio and a fee waiver of .43% that is effective until September 30, 2012. This ETF will place 80% of assets into covered bonds, with the remainder to be invested in securities that reflect index performance.
Thus, a covered bond ETF has been placed into the hands of smaller investors and is no longer the exclusive province of well heeled and institutional investors.