ProShares, the issuer behind a number of the ETFs offering exposure to alternatives, has notched another first for the ETF industry this week with the debut of a Covered Bond (COBO) product. The new ETF will seek to replicate the BNP Paribas Diversified USD Covered Bond Index, a benchmark that includes dollar-denominated covered bonds that are generally rated AAA.
Covered Bonds 101
Covered bonds are a unique type of debt instrument, generally issued by financial institutions and secured by a separate group of assets known as a “cover pool”. The so-called cover pool can include various types of assets, but generally includes mortgages and public sector loans. Covered bonds are similar to traditional corporate bonds in that they originate from corporate issuers, and are similar to asset-backed securities created through securitization [see also Bond ETFs For Every Objective].
Holders of covered bonds have senior unsecured claims against the issuing financial institution, which is backed by the cover pool in the event that the bank defaults on its obligation. Because the assets that make up the “cover pool” remain on the books of the bank that issues the debt, those institutions must ensure that the underlying pool of assets can back the bank’s obligations [see also 12 High-Yielding Monthly Distribution Bond ETFs].
Covered bonds are a relatively new innovation; they were developed originally in Europe, and were first introduced into the U.S. market in approximately 2006. Initially, covered bonds were given very high quality credit ratings since these obligations were backed by a pool of separate assets. Credit ratings on some covered bonds of U.S. banks were dropped during the recent financial crisis as investors realized that the underlying bonds–including mortgages–were of low quality. However, many covered bonds retained relatively high credit ratings throughout the crisis. Changes made to ratings methodologies since then require even more substantial over-collateralization to receive the highest ratings, further indicating the relatively low risk of these securities [see also Better-Than-AGG Total Bond Market ETFdb Portfolio].
Ratings on covered bonds have recovered since the depths of the recent recession, with many of these securities now rated AAA. In order to be eligible for inclusion in the underlying index, covered bonds must be
- denominated in U.S. dollars
- have a fixed-rate coupon
- have at least 18 months to maturity
- have $1 billion or more of outstanding face amount
- be rated AAA (or equivalent) by Fitch, Moody’s, or S&P
Under The Hood
The underlying index currently consists of about 43 different bonds from 20 different issuers. The financial institutions behind the COBO portfolio are primarily from Canada and Europe, with the largest allocations by country going to:
- Canada (59%)
- Norway (12%)
- Switzerland (9%)
- Australia (6%)
- France (6%)
- England (3%)
There are also some caps on weights afforded to individual institutions; no single issuer may have value weight greater than 25% of the value of the index, and issuers with a value weight of 5% or more may not constitute more than 50% of the value of the index.
COBO will charge a net expense ratio of 0.35%.
Disclosure: No positions at time of writing.
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