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Wednesday, 24 September 2014

A working duopoly

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Switzerland is unique in its covered bond market, having only two institutions permitted to issue such instruments. Through this duopoly, Swiss financial institutions can access funding, seemingly regardless of market conditions, with spreads suffering only minor corrections compared to the rest of Europe. Rachelle Horn reports.

Mortgage funding has been an especially topical subject since the onset of the global credit crisis. Global credit woes rocked both the RBMS and the covered bond markets. Yet the Swiss Pfandbrief sector has continued to hold its position as one of the most important bonds in the Swiss domestic market.

One distinguishing feature of the Swiss framework, established by the Pfandbriefgesetz (Pfandbrief law) of 1930, is the existence of only two domestic institutions entitled to issue Pfandbriefe: Pfandbriefzentrale der Schweizerischen Kantonalbanken (PfZ) and Pfandbriefbank Schweizerischer Hypothekarinstitute (Pfandbriefbank).

PfZ acts as the issuing vehicle for the Cantonal banks, while Pfandbriefbank looks after the remaining banking institutions. Both bodies pool the refinancing needs of their respective member banks by granting secured loans to their member banks, refinancing them via covered bonds – or Pfandbriefe – with the same maturity. The two are of a roughly comparable size: as of March 2007, the Pfandbriefzentrale had issued Pfandbrief worth around SFr23.8bn, compared to Pfandbriefbank’s SFr22.5bn.

Both issuers are supervised by the Swiss Federal Banking Commission and are rated Aaa by Moody's. Loans to members are on a fully matched basis, with issuance in Swiss francs only. The LTV on Swiss mortgages eligible for inclusion in asset pools is limited to two-thirds, and the two issuers' bonds trade roughly in line with each other. The Swiss system benefits from good transparency; details of the mortgages are readily available to the lending vehicles.

In early 2007 global credit markets were benefiting from a positive spread environment and both PFZ and Pfandbriefbank were accessing funding at record tight levels. Pfandbriefbank funded a 12-year tenor at mid-swaps minus 15bp in February last year. By the end of April 2008 it priced a bond in 10-years at 11bp through. Clearly Swiss covered bonds have not been immune to the credit troubles but compared to other European markets – pricing at double digits through Libor is a distant dream for German Pfandbrief borrowers – their spreads have experienced a mere correction.

The relative illiquidity of the Swiss franc bond market generally ensures its secondary bonds trade incredibly tight, and this has also helped Switzerland's Pfandbrief spreads. More importantly, the two Pfandbrief issuers benefit from a very strong domestic bid. Matthias Signorell, director of the Credit Suisse DCM team in Switzerland, said a reduction in the Swiss government bond supply over recent years has been vital in accentuating demand.

Since 2005 there has been a sharp fall in government confederation and Cantonal issuance, both benefiting from the proceeds of gold sales, leaving the Swiss franc market decidedly short domestic bonds. Spreads have subsequently moved in line with this supply and demand imbalance, leaving covered bonds as the best alternative, thanks to their relative liquidity, large size and Aaa ratings.

In some European jurisdictions, like Spain, pooled covered bonds are often seen as poorer quality than their single-name counterparts. In Switzerland, however, the duopoly is generally deemed very efficient. Over 200 member institutions have access to advantageous-cost funding and even global heavy-weight banks like Credit Suisse and UBS have the incentive to refinance mortgages through the Pfandbriefbank. UBS recently priced a SFr300m April 2012 bond at 110bp over mid-swaps.

Thomas Jordan, member of the governing board of the Swiss National Bank, is an unsurprising advocate of the product; he recently said he believed the weaknesses of mortgage bonds, revealed by the financial market crisis, do not apply to Swiss mortgage bonds.

"Consequently, it should definitely have the potential to play an even greater role in maturity-matched refinancing of mortgages in Switzerland in the future," he said. "In addition, banks can improve their liquidity by holding portfolios of Swiss mortgage bonds themselves. Mortgages can be converted into liquidity quickly and simply, as required, by means of repo transactions – either in the Swiss franc interbank market or at the SNB."

However, there has never been such a thing as a perfect market, and the Swiss Pfandbrief sector is no exception. "Domestic Swiss franc bonds are subject to new issue tax to be born by the issuer and withholding tax which is not very lucrative for foreign investors," said Signorell. "As such, the pool of potential investors cannot be extended outside of Switzerland, which means that even when demand from the member banks is high there is a potential limitation on demand from the investor side."

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