Investors consider fixed income and liquidity for a variety of reasons. Many of which will change as markets rise and fall, but certain characteristics are always attractive – notably resilience, income and liquidity.

Government bonds offer high credit quality, excellent liquidity but limited spread; corporate bonds may offer more income, but come with greater risk. Sitting between these two areas is an often-overlooked part of the fixed income market: covered bonds.

Covered bonds are widely used by banks and building societies as a source of funding, but they are sometimes misunderstood by investors. They can be wrongly grouped with mortgage-backed securities, viewed as just another form of bank debt, or dismissed as too low-yielding to be useful. In practice, we believe that covered bonds have a distinctive structure that provide a unique mix of security, yield and liquidity that makes them a useful addition to diversified fixed income portfolios.

At Royal London Asset Management, we see covered bonds as a useful way to gain exposure to high quality financial issuers, while benefiting from additional structural protections and potentially attractive relative value.

What are covered bonds?

A covered bond is a specific type of secured bond. These are usually issued by a bank or building society and typically backed by a pool of high quality assets, primarily residential mortgages. A UK institution wanting to issue a regulated covered bond or covered bond programme has to comply with the Regulated Covered Bonds Regulations 2008 and Regulated Covered Bonds

Sourcebook. All regulated covered bonds are listed on a register1 (there are similar regulations in a number of other jurisdictions including Canada, Australia, Singapore and Scandinavia, deepening the universe of covered bonds we consider).

The defining feature of a covered bond is dual recourse. This means investors have two sources of repayment. First, they have a claim on the issuing bank, which remains responsible for paying interest and principal. Second, if the issuer defaults or becomes insolvent, investors have a preferential claim on the assets in the cover pool.

This structure differentiates covered bonds from both senior unsecured bank debt and securitised assets. With senior unsecured debt, investors rely primarily on the bank’s ability to repay. With many securitisations, investors primarily rely on the performance of a specific pool of assets. Covered bonds combine elements of both: the issuer remains on the hook, while investors also benefit from a dedicated pool of collateral.

Figure 1: How the cover pool supports the bond

Source: RLAM. For illustrative purposes only

Another important feature is the asset pool itself, which is held separately from the issuer – this feature protecting bond holders if the issuing bank fails. The FCA sets out requirements for the pool that insist on quality of the mortgages contained, as well as a minimum level of over-collateralisation, then carries out its own periodical stress testing rather than accepting credit agency ratings. In addition, the pools are dynamic. Hence mortgages that are refinanced or fall into arrears can be replaced with new assets of similar credit quality and characteristics. This helps maintain the quality and value of the collateral supporting the bonds.

Most sterling covered bond issuance is floating rate – typically paying a premium over SONIA for the life of the bond, which is usually five years or less. Floating rate instruments have lower interest rate risk than fixed rate securities, which typically means lower price volatility – a key consideration for cash and near-cash investors.

We believe that the combination of floating rate, shorter duration, dual recourse and the quality of asset pool is an attractive one for investors. Yet many remain unsure or suspicious of these securities.

Misconception 1: “Covered bonds are the same as mortgage-backed securities”

This is probably the most common misconception, one with its roots in the Global Financial Crisis where US mortgage-backed securities were one of the main underlying reasons for the instability in US capital markets. Covered bonds and residential mortgage-backed securities can both involve mortgage assets, but their structures are materially different.

In a mortgage-backed security, the investor is exposed to the cashflows from a pool of mortgages, with the underlying issuer at arm’s length in the event of default – or in technical terms, the pool is ‘off balance sheet’. In a covered bond, the issuer bank remains responsible for repayment, and the cover pool is ‘on balance sheet’, providing additional security. If the issuer defaults, the asset pool takes responsibility for continuing payments to bondholders.

This distinction matters because it changes the alignment of incentives. Covered bonds are not simply a way for banks to package up assets and transfer the risk away. Because the pool remains on the issuer balance sheet, the issuer remains central to the structure. For investors, that means analysis must consider both the strength of the issuing bank and the quality of the cover pool.

Misconception 2: “Covered bonds are just risky bank debt”

Covered bonds are issued by banks and building societies, so they do involve exposure to financial institutions. But they are not the same as ordinary bank debt.

The dual recourse structure provides an additional layer of protection. Investors are not relying solely on the issuer’s balance sheet; they also have a preferential claim over the segregated cover pool if the issuer fails. The more stringent regulation and quality of the cover pool means that the majority of covered bonds are AAA rated.

This does not mean covered bonds are risk-free. Investors still need to assess issuer strength, collateral quality, property market exposure, legal structure, liquidity and valuation. But covered bonds generally sit at a more secured point in the bank capital structure than senior unsecured or subordinated bank debt. In our view, this can be useful in portfolios where investors want exposure to financial issuers but with a more defensive risk profile than traditional senior or subordinated bank debt.

Misconception 3: “Covered bonds do not offer enough yield to matter”

Covered bonds typically offer a lower spread than senior or subordinated debt. As mentioned above, the risk profile of covered bonds is lower than regular bank debt, and hence a lower spread is appropriate.

However, they may offer incremental income over government bonds or other very high quality assets, while retaining strong structural protections. For investors focused on risk-adjusted return, that combination can be powerful. The appeal is not simply the absolute level of yield, but the relationship between yield, credit quality, liquidity and downside protection.

This is where active management matters. Covered bond spreads can move relative to government bonds, senior bank debt and other secured assets. Differences between issuers, jurisdictions, collateral pools and deal structures can create opportunities for investors willing to do the detailed credit work.

Misconception 4: “Covered bonds are too niche or illiquid”

The UK covered bond market is smaller than some European markets, but covered bonds are an established part of the institutional fixed income universe, governed by specific legislation introduced in 2008.

Liquidity can vary by issuer, maturity and market conditions, but their nature means there is a well-established investor base. The shorter maturity nature of the bonds increases natural liquidity and regular issuance creates benchmarked-sized deals. In addition, covered bonds are eligible as collateral, meaning banks can post these to access central bank liquidity facilities. In addition, UK and European bank covered bonds are eligible as HQLA (high quality liquid assets). As a result, regulators allow banks to hold eligible covered bonds as part of the liquid assets they must keep to meet potential cash outflows. Only UK and European bank covered bonds are eligible collateral in Europe. This often means that these have tighter spreads than covered bonds issued by other banks, but this is also a point of difference that active managers can benefit from.

Why we use covered bonds

We use covered bonds because they can offer a compelling combination of quality, security and relative value. First, they can support capital preservation. The dual recourse structure, ringfenced cover pool and regulatory framework provide protections that are not available in ordinary unsecured bank debt.

Second, covered bonds can provide a controlled way to generate additional spread. They typically offer more income than government bonds, but with a lower-risk profile than many other forms of credit. This makes them attractive for portfolios such as our liquidity and short-term fixed income strategies, that aim to generate attractive yield while remaining more defensive than other credit strategies.

Third, they allow for diversification within financial credit. Not all bank exposure is equal. Covered bonds, senior unsecured debt and subordinated debt each carry different risks and rewards. Covered bonds can help investors access the banking sector from a more secured position in the capital structure.

Do the work

Finally, covered bonds are well suited to our active, research-led approach. We do not view them as a passive allocation or a generic ‘safe’ asset. We analyse issuer fundamentals, collateral quality, structural protections, valuation and relative value. That means looking not only at the headline rating, but also at the resilience of the underlying assets, the strength of the bank and the compensation offered for the risks being taken. So while we like covered bonds conceptually, our weighting to this asset class will vary according to the value we see in these on a bottom-up basis.

[1] https://www.fca.org.uk/firms/regulated-covered-bonds/register

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied.