All eyes on Denmark
The Nordic covered bond markets are among the oldest and most respected in the world. But for an asset class that prides itself on a dependability that borders on the boring, falling house prices and persistent regulatory debates have injected a little excitement into the Danish market.
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Relative to its Nordic peers, Denmark has suffered an acute housing downturn, coupled with a number of bank failures. It is also renowned for having one of the toughest financial regulators in Europe, one that has been more aggressive than most in imposing losses on bondholders.
Indeed, Denmark’s is an extremely idiosyncratic market, where individual home-owners are free to hedge their own mortgages. “The Danish have probably the most developed mortgage market in the world,” said Mauricio Noe, head of senior and covered bonds, EMEA at Deutsche Bank. “Banks need extra tools to allow them to hedge this optionality given to home-owners.”
Others have tried to replicate what the Danes have built, but none have succeeded. Therefore, developments in the Danish mortgage or covered bonds markets may not therefore be applicable in other countries.
Take junior covered bonds. These instruments have existed in Denmark since around 2005 on a private basis, said Ben Colice of RBC. “As rules and liquidity conditions evolve we will probably see a lot more of it,” he said.
Would these make sense in other markets? Since the financial crisis, covered bonds have become very expensive, testament to the asset class’s performance at a time when many others have struggled. This has led some investors to look for cheaper alternatives – hence the interest in junior covered bonds, which offer many of the same features, but with a little more risk and return built in.
“Junior covered bonds, ranked on a par with senior unsecured but benefiting from security on cover pools – [and therefore not subject to a] bail-in – and giving investors a bit of spread, could work,” said Boudewjin Dierick, in the financial Institutions solutions team at BNP Paribas. “It would need legislation in other countries, but most will want to see how things develop in Denmark before they commit to it.”
However, some are concerned about the impact junior deals would have on the traditional covered bonds. “Some new investors would certainly like a new product, but it is important that nothing dilutes the existing brand,” said Colice. “It begs the question: what actually is a covered bond? Some labels have been proposed that could alienate potential issuers, such as Canadian and Australian banks, who are new to the asset class but have been embraced so far by investors. There is a natural tension between the desire to maintain the traditions of the product and respecting what investors want.”
For this reason, and from a marketing perspective, some feel it is pertinent to avoid references to junior covered bonds at all. “We prefer to call them senior secured bonds, which better reflects the characteristics of the asset class,” said Monika Rast, head of origination, international financial institutions at UniCredit.
The product evolved in Denmark to allow borrowers to maintain proper collateralisation in their cover pools amid falling house prices, or if needed to satisfy rating agencies’ requirements for higher overcollateralisation. “But other countries have found their own solutions to these problems”, said Rast.
“The main thing is that senior secured bonds are a solution to fill a potential overcollateralisation-need in a cover pool,” she said. “They are not an instrument to fund new business and are therefore no funding alternative. The two products are not conflicting and therefore covered bond issuance volumes will not be influenced.”
And with such tight spreads between senior unsecured and covered bonds, it may not be the most auspicious time to be launching products that find a home in the territory between these two existing products.
Investment of last resort
“During the height of the crisis covered bonds became somewhat volatile and illiquid, though to be fair that is true of all markets except Bunds and Treasuries,” said Noe.
Banks need liquid assets to meet their liquidity cover ratio targets, but due to their recent volatility some do not view covered bonds as appropriate investments under category one.
There are four times the value of covered bonds in Denmark as there are Danish government bonds. An absence of alternatives in the Danish system has led to covered bonds in the kingdom being classified as rates products, meaning they count as liquid assets.
“The Basel Committee made provisions in the LCR for countries like Denmark, Australia, Norway and Singapore, where there is little government debt to invest in – or a heavily reliance on covereds as in Denmark – allowing them to invest more heavily in covered bonds instead,” said Noe.
Other countries may end up having their covered bonds classified as level one assets as well, with the EBA due to publish a report into this question soon. There is some debate as to how many other jurisdictions the same logic could apply to, born out of the unspecific wording of the capital requirements regulation, which requires instruments to be “extremely high liquidity and credit quality”.
The VDP in Germany is pushing hard for Pfandbriefe to be given category one status, and it is not alone: if the case can be made for Nordic covered bonds to be given level one status, a similar case can be made in Sweden, France and others.
On calmer waters
Elsewhere in the Nordic region the covered bond market has been closer to its usual tranquil self. Issuance has dipped a little year on year, but this is partly because the funding needs of Nordic borrowers are lower than they were last year, particularly in Sweden, said Jussi Harju, a covered bond analyst at Barclays.
It is also a sign of broader market health, said RBC’s Colice. When other markets are closed issuers turn to covered bonds to raise capital, but when the senior unsecured and other markets are open, they will diversify, meaning less issuance in the covered bond market. “It is not evidence issuers are turning away from the product,” he said.
Yet it does illustrate the relative appeal of other routes to funding where they are available. “The spread differential between covered bonds and senior unsecured is very tight, around 30bp–40bp in Sweden,” said Harju. “That is not necessarily enough to justify the additional collateral you have to give up to issue covered bonds.”
In Sweden the domestic market has been particularly active, skewing issuance away from the euro market, but in Norway the domestic market has been less active, leading to more euro issuance.
Traditionally Sweden has been a larger covered bond market than Norway, both in terms of domestic and non-domestic markets. However, in 2012 Norway overtook Sweden in terms of non-domestic outstandings on the back of strong supply (€13.4bn equivalent by Norwegian issuers vs €5.0bn equivalent by Swedish issuers). At the end of June 2013, outstanding Norwegian non-domestic covered bonds totalled €45.9bn versus €44.4bn equivalent in Sweden.
Both Sweden and Norway are considerably larger markets than Finland or Denmark when measured by non-domestic outstanding covered bonds, with €23bn of Finnish and only €10bn of Danish covered bonds outstanding. However, the picture changes dramatically when domestic currency covered bonds are factored in. Sweden, for instance, has the equivalent of €226bn of covered bonds outstanding, while Denmark’s enormous domestic market makes it the largest Nordic covered bond market, with €392bn outstanding as at March 2013.
Nordic countries generally, though, have been more active in the euro and dollar markets in recent months, thanks to an increasingly favourable basis swap market, which ebbs and flows according to interest rate differentials and cross-border currency flows.
There is always a strong incentive to issue in a range of currencies when the cross-currency swap market allows, for diversification, and issuance has come of late despite domestic markets still offering a better deal. The dollar tends to offer the best execution while the euro offers the best duration.
The fact that covered bonds supply struggles to keep pace with demand, particularly in the euro and dollar markets, is encouraging opportunistic issuance. Yet some borrowers are so well regarded that they do not typically adopt an opportunistic mindset, instead basing decisions on cost and their asset liability matching needs.
Banks like Sweden’s SEB and Handelsbanken, and DNB Nor in Norway, have very international businesses that steer them towards issuance in a range of currencies. Institutions with a greater focus on domestic mortgages will have more incentive to issue local currency covered bonds.
Issuance is also set to be determined, in large part, by redemptions in coming years, which will be low for the next few years. Norway, for example, will have around €4.2bn of redemptions in foreign currency covered bonds in 2013, and less than €1bn in 2014. Redemptions will spike between 2015 and 2017, meaning there may be more foreign currency issuance then, though forecasting that far into the future is tricky.
Pfandbriefe, perhaps the world’s most renowned covered bonds, are always popular with investors because the market is so well supported by German investors. “It becomes a self fulfilling prophecy,” said Noe. But if one is able to screen out this domestic dynamic, Nordic covered bonds are perhaps even more cherished by investors, he said.
Investors especially like the fact Nordic covered bonds tend to incorporate country-specific cover pools, said Rast.
“Investors like those pure cover pools because they would like to manage the diversification themselves rather than buying into mixed pools,” she said.