Everything You Need To Know About Covered Bond ETFs (COBO, PRB, QLTA, QLTC)

Michael Johnston: Last week marked yet another first for the ETF industry, as ProShares rolled out a product that delivers access to a unique corner of the fixed income market. The new ProShares Covered Bond (NYSEARCA:COBO), as the name suggests, offers access to securities known as “covered bonds.” That name makes reference to a unique form of credit enhancement utilized to lower risk, and distinguish these securities from traditional corporate debt. Most U.S. investors are probably unfamiliar with covered bonds; the market for these securities is small and young in the U.S., though it has been more developed in Europe for much longer. But thanks to COBO and some other recent developments, covered bonds are now becoming widely available to all types of investors [for ETF analysis and insight, sign up for the free ETFdb newsletter].

For those looking for low-risk fixed income securities–and seeking options besides U.S. Treasuries–covered bonds could be an interesting options. Below, we provide an overview of these bonds, including a look under the hood and analysis of relative risk and return.

Covered Bonds 101

Covered bonds can be thought of as a subset of the corporate bond universe, and specifically as a subset of corporate bonds issued by financial institutions. What makes these bonds different is a separate basket of securities known as a “cover pool” that is used to secure the obligations of the issuing institution (issuers of covered bonds include Toronto Dominion Bank, Royal Bank of Canada, UBS, and Bank of Montreal). This cover pool generally consists of mortgages and public sector loans, and is used to support claims of covered bondholders in the event that the bank defaults on its obligations.

[see 101 ETF Lessons Every Investor Should Learn]

In other words, investors have an opportunity for recourse even if the issuing financial institution were to collapse or default. In that case, the pool of cover assets could be accessed by investors, making them whole on their original investment. That puts covered bondholders in a better position than holders of traditional debt issued by financial institutions, since issuers of the debt have essentially put aside securities that can be used to repay the obligations. If issuers of traditional corporate debt default or go bankrupt, bondholders generally expect to receive little or no return on their investment.

Covered bonds are in a way similar to pre-refunded municipal bonds, which can be accessed through the Market Vectors Pre-Refunded Municipal Index ETF (NYSEARCA:PRB). When issuers of muni bonds want to refinance but are restricted from calling outstanding bonds, they can create a pool of Treasuries that secures the principal and interest due under their outstanding debt. Because of these protections, the risk of default on a covered bond is extremely low. Not surprisingly, the covered bond market was very resilient during the recent financial crisis, and was one of the first to recover.

Covered bonds are almost always rated AAA (or equivalent) by the three major ratings agencies.

Covered Bonds: Risk & Return

Given the credit enhancements generally offered by the presence of a cover pool, it should be no surprise that covered bonds are generally considered to be some of the safest fixed income securities available. With two layers of protection from default, investors can be reasonably certain that they will be able to recover their initial investment. As such, they generally won’t demand huge returns in exchange for holding covered bonds; this asset class will typically offer yields that are quite a bit lower than traditional corporate bonds [see the High Yield ETFdb Portfolio ETFdb Pro Members Only].

As such, covered bonds may be most appropriate for investors seeking low risk positions, and willing to accept relatively low returns. Covered bonds will generally offer a level of risk and expected yield that are lower than traditional corporate bonds. The following table shows the weighted average coupons for COBO compared to a number of other corporate bond ETFs of various quality. (NYSEARCA:QLTA) holds only corporate debt with the highest possible credit ratings, while (BATS:QLTC) holds a basket of very risky securities. As would be expected, COBO’s yield is at the low end of the spectrum, reflecting the significantly lower risk from the underlying securities.

History Of Covered Bonds

U.S.-based investors generally assume that U.S. banks are on the cutting edge of developing new financial products. But when it comes to covered bonds, we’re actually centuries behind the Europeans. Covered bonds have been around in Europe since the 18th century, when Frederick the Great of Prussia pioneered the new security. Since then usage has grown steadily; in 2011 European banks issued more than $330 billion of covered bonds.

But their entrance into the U.S. market has been repeatedly delayed due to a lack of regulatory infrastructure. Specifically, the U.S. has not laid out the details of what happens to covered bonds if the underlying banks were to default on their obligations. Proposed legislation would open up the doors to this new type of security, and the initiative has the backing of legendary investor George Soros.

The SEC recently approved a program that would see Royal Bank of Canada sell $12 billion of covered bonds in the U.S. as registered securities. Historically, international banks have sold covered bonds into the U.S. market as private placements, thereby restricting them to institutional investors and mutual funds. If sold as registered securities, covered bonds could be purchased by retail investors.

COBO: Under The Hood

COBO’s portfolio currently consists exclusively of debt issued by non-U.S. institutions, including banks in Canada and Europe. There are currently about 35 different securities that make up the fund, though only about 20 unique issuers.

COBO has an adjusted duration of just over three years, and an average yield to maturity of about 1.5%.

COBO’s Index
Number of Securities 36
Modified Adjusted Duration 3.31 Years
Weighted Average Maturity 3.33 Years
Average Yield To Maturity 1.48%
Weighted Average Coupon 2.10%
Weighted Average Price $102.03
Data for Underlying Index, as of 3/31/2012

Written By Michael Johnston From ETF Database Disclosure: No Positions.

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