It is time to consider the virtues of "covered bonds," which are debt instruments with a certain preferential claim in the event of default. With traditional bond markets not behaving according to the playbook, investors should pay attention, the author says.

Where can investors find safety in a world where government bonds have at times fallen in step with equities? What choices are available? Henrike Stille, portfolio manage at the Covered Bond Opportunities strategy of Nordea Asset Management discusses the topic. 

Stille argues that Europe’s “covered bond” market holds promise. According to a description by the European Covered Bond Council, such bonds are “debt instruments secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default.” Stille points out that although such a preferential claim, as well as other safety features (asset eligibility and coverage, bankruptcy-remoteness and regulation) depends on the specific framework under which a covered bond is issued, it is the safety aspect that is common to all covered bonds.

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For investors seeking a haven to turn to in today’s turbulent markets, the list of reliable options is shrinking.

Events in recent weeks have delivered a stark warning to those who thought that traditional ballast assets could still be relied upon to cushion portfolios from sharp equity market drawdowns. As risk assets trembled in response to US President Donald Trump’s announcement of sweeping tariffs on imports from across the globe, many investors encountered a painful realisation.

While global equities fell sharply during the Trump tariff turmoil at the beginning of the month, with some US indices dropping into bear market territory, treasury bonds were selling off in tandem with stocks at one point. This is not how government bonds – which have long been the defensive diversification counterweight within investor portfolios – should behave. 

Even though European government bonds managed modest gains as the region’s equity markets fell sharply during the tariff volatility, the safe-haven credentials of these government debt markets have also been questioned this year. In early March, European government bond yields surged after German Chancellor Friedrich Merz unveiled a dramatic defence and infrastructure stimulus package.

With most market participants expecting ongoing instability in an era of elevated fiscal deficits and heightened geopolitical risk, can government bonds be relied upon to provide the needed portfolio protection? Against this volatile backdrop, investor attention will likely shift towards a lesser-known but increasingly relevant corner of fixed income: the €2.5 trillion ($2.81 trillion) European covered bond market.

No defaults in more than two centuries
European covered bonds are fixed-income securities issued by banks or mortgage lenders, backed by pools of high-quality assets such as residential mortgages or public-sector loans. Their dual protection structure sets them apart – investors have recourse to the issuing bank and the segregated cover pool of assets, which is typically over-collateralised.

This unique framework has ensured that covered bonds have never suffered a default in more than 200 years. Indeed, history shows that covered bonds have often proved to be safer than government debt. During the European sovereign debt crisis over a decade ago, Greek government bondholders took heavy losses in a debt restructuring – yet holders of Greek covered bonds recovered their investment in full. More recently, covered bonds were exempted from Europe’s bank bail-in regime, sparing investors from the losses endured by senior debt holders of Banco Espírito Santo in 2016.

Encouragingly, European covered bonds have demonstrated resilience during this year’s market dislocations. During the tariff turmoil, covered bonds participated in the modest gains posted by European government bonds. Crucially, however, they avoided the sharp losses suffered by government debt following Germany’s dramatic stimulus announcement. As the European government bond benchmark fell by more than 2 per cent in just two days, covered bonds delivered positive returns.

The robust characteristics of covered bonds – particularly shorter-duration securities – have been repeatedly demonstrated throughout the tumultuous period that perceived safe-haven assets have experienced since the start of the decade. While short duration covered bonds, exemplified by the Iboxx Euro Covered Interest Rate 1Y Duration Hedged index, did decline by 1.4 per cent and 4.3 per cent in 2021 and 2022, respectively, this demonstrated significant downside protection compared with the sharp losses incurred by the broader European government bond market.

No supply crunch in covered bonds
While the appeal of covered bonds lies partly in their defensive qualities, their structural market dynamics also offer compelling support for investors for the remainder of 2025 and beyond. In contrast with government bonds – where rising fiscal deficits and spending plans are driving huge increases in supply –European banks are issuing fewer covered bonds than in the past. With capital ratios strong and regulatory requirements stable, issuance is relatively subdued.

In other words, investors in covered bonds are not facing the same looming supply glut that threatens to weigh on government bond markets. Add an attractive yield pickup over sovereign debt, and the case for covered bonds strengthens further.

Finally, while investors may still perceive covered bonds as a sleepy, passive-friendly asset class. This is a misconception. The covered bond market remains inefficient, with spreads often moving sharply due to country-specific or issuer-related factors. This presents an opportunity for active managers to generate outperformance – even within a conservative, defensive allocation.

With geopolitical risk rising, fiscal policy becoming more expansionary, and traditional government bonds losing some of their safe-haven status, covered bonds represent an under-the-radar diversifier likely to come into sharper focus.

About the author

Henrik Stille is portfolio manager of Nordea’s Covered Bond Opportunities strategy, having joined the firm in 2005. He manages a range of fixed income funds, including covered bonds, government bonds, and supranational, sub-sovereign, and agency (SSA) securities across G10 currencies. Stille oversees multiple funds that leverage relative value opportunities within the rates asset classes. Prior to joining, Stille worked as a commodity trader in the United States. He holds an MSc degree in economics from Lund University in Sweden.