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A man walks past in front of an ATM machine at Spain's Bankia in Madrid August 31, 2012.

JUAN MEDINA/REUTERS

Investors could earn juicy yields buying beaten-up covered bonds secured on Spanish mortgages. The snag is that no one can really tell what would happen in a covered bond default.

It's hard not to be tempted by the yields on offer on some Spanish mortgage covered bonds, securities that rank alongside senior debt, but have a priority claim on the banks' real estate loans. Take Bankia, the soon-to-be-recapitalized lender, whose such bonds maturing in May 2018 are yielding almost 9 per cent, according to Thomson Reuters prices, about three percentage points more than Spanish government securities.

Yields would fall sharply if the euro zone follows up on its promise to create a banking union, where lenders are centrally regulated and recapitalized. It's also hard to see covered bonds taking a principal loss. Euro zone governments are still wary of forcing losses even on unsecured bank creditors – they recently shied away from it in Spain's bank rescue. Haircutting covered bonds would be much more controversial, since the securities are revered as risk-free in Germany, where they were invented.

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Even if a bank failed, the bonds would be protected by the assets that would be sold to meet maturing debt. Take Bankia. At the end of the first quarter, each euro of its covered bonds was backed by 2.08 euros worth of residential and commercial real estate loans according to Moody's. Assume a stressed scenario similar to the Irish housing downturn, as modelled by Fitch Ratings. The collateral would still fetch enough to cover 111 per cent of the debt, even after deducting expected losses from defaults and assuming each loan had to be sold for 70 cents of its nominal value, according to a Breakingviews analysis.

Still, there are reasons to be wary. First, the amount of collateral backing the bonds is not set in stone; it would reduce over time before default, say if a bank issued lots of covered bonds to the European Central Bank. Second, it's hard to see who would buy the loans in an extreme, systemic crisis. Losses could be even steeper if Spain left the €.

Current yields may provide ample compensation for those risks, but given the uncertainties, bottom-fishers need to believe that Spain can avoid the worst.

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