How's this for irony: One of the most attractive fixed-income opportunities for conservative investors these days is high-quality bonds that are backed by mortgages and yield about 40 basis points above comparable five-year Treasuries.
Called covered bonds, these debt instruments are obligations of banks that retain the mortgages they write on their balance sheets. What they're not are mortgage-backed securities, which gained infamy during the financial crisis for holding messy and mysterious pools of subprime home loans.
“These are high-quality assets, and for some investors, it's all about quality and income,” said Rich Sega, chief investment officer at Conning & Co., a $77 billion asset management company.
While covered bonds are relatively new to the United States, they represent a $3 trillion global market that is fully developed in Canada and has been around for more than 200 years in Europe. Last year, foreign financial institutions issued nearly $30 billion of covered bonds to U.S. investors. Estimates are that this year will see similar volume, according to the Securities Industry and Financial Markets Association.
But even though the bonds are sold through local brokerages and issued in U.S. dollars, investors should be aware that the legal framework of the bonds is covered by the jurisdiction in which they were issued.
“It has been opportunistic for foreign financial institutions,” said Sean Davy, a managing director at SIFMA. “We believe with all the changes in the marketplace, covered bonds would represent another tool that offers long-term funding [for financial institutions] and does so with new investors.”
The development of a formal U.S. market for covered bonds was proposed for inclusion in the Dodd-Frank legislation but was cut at the last minute.
The bill, sponsored by Rep. Scott Garrett, R-N.J., now chairman of the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises, and Rep. Carolyn Maloney of New York, the ranking Democrat of the House Financial Services Subcommittee on Financial Institutions and Consumer Credit, is designed to clarify where bondholders would stand in the event of insolvency by the issuing bank.
The covered-bond bill is expected to get a vote by the full House Financial Services Committee within weeks.
While the legislation is still being scrutinized by the Federal Deposit Insurance Corp. because of where the covered bondholders rank as creditors, most industry watchers expect to see a law paving the way for a domestic covered-bond market by next year.
“I like the concept because it's more like old-school banking,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts. “It has legislative appeal because it reduces risk and it's easier to understand. If we had been running covered bonds instead of mortgage-backed securities, it might have changed some of the incentives around the housing crisis.”
Covered bonds are not seen as a replacement for mortgage-backed securities, which saw $100 billion worth of issuance last year, down from $900 billion in 2006.
But covered bonds are seen as a way to replace some of the slowdown in issuance by traditional mortgage pools.
In addition to the security of being held on a bank's balance sheet, covered bonds also have the flexibility to replace poor-performing mortgages in order to maintain a bond's overall quality.
“One of the missions [of financial reform] is to get banks to retain more of the housing finance market, and this is the next stage of evolution in mortgage finance,” Mr. Sega said. “Covered bonds aren't going to be able to fix the housing crisis, but they will help to replace some of the capacity of the mechanism that facilitates lending.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
