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A covered bond (in French: lettre de gage and German: Pfandbrief) is a debt security issued by a covered bond issuing bank and guaranteed by a cover pool specifically allocated to these securities. Unlike asset backed securities (ABS), covered bonds are on-balance-sheet for the issuing bank.

The issuance of covered bonds is restricted to specialist banks that have been incorporated for this purpose. These banks are subject to supervision by the Luxembourg supervisory authority, the CSSF, as well as by an auditor specifically appointed to monitor the cover assets of a bank issuing covered bonds.  The regulatory framework for covered bond issuing banks is laid down in the law of 21 November 1997, as amended.

Three types of covered bond are issued in Luxembourg:

• the lettre de gage “publique” (or public sector loan backed bond) guaranteed by claims against, or guaranteed by, public entities (such as the European Union, the European Economic Area, or the OECD), the state sector or public local entities,
  
  
• the lettre de gage “hypothécaire” (or mortgage loan backed bond) guaranteed by rights in or security interest over real estate and,
  
  
• since 2008, the lettre de gage “mobilière” (or moveable asset backed bond) guaranteed by assets such as ships, aircraft, boats and trains which are registered in public registers in the EU, EEA or the OECD.  The list of these cover assets is not limitative; the CSSF may authorise additional cover assets.

Covered bond issuing banks benefit from a derogation in the bankruptcy legislation whereby creditors have direct access to the bank’s assets in case of insolvency. Due to the high level of investor protection this affords, securities issued generally benefit from AAA credit ratings.

Furthermore, due to the international dimension of the Luxembourg law these banks may lend to borrowers domiciled in all OECD countries.  This enables the banks to apply a policy of international diversification, with the result that Luxembourg covered bonds are less vulnerable to the risk of downgrading of sovereign ratings.