Tuesday, 22 January 2019


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A super-safe asset class that has survived the last six years with its 200-year old reputation intact still needs protecting. Covered bonds have been bullet-proof so far, but all parties need to be alert to the unintended consequences of a flurry of regulatory action.

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Social security, as they say in Washington DC, is the third rail of American politics: full of voltage. Touch it, and you die.

Much the same could be said, in the high priesthood of debt finance, about covered bonds. They are sacrosanct, inviolable, an apparently sacred asset class.

In recent years investment banks, retail lenders, even whole countries, have fallen by the wayside. This year alone three European lenders (Co-operative Bank, SNS, and the venerable Italian outfit Banca Monte dei Paschi di Siena) and one tiny exposed eurozone state (Cyprus) have been restructured, nationalised or bailed in.

In each case, senior or junior bondholders (or both) have taken a haircut on their investment. In the case of Britain’s Co-operative, owners of subordinated debt are likely to see some or all their assets converted into equity as the bank readies for a mooted London Stock Exchange flotation.

Through it all, covered bonds have remained untouched and untouchable. However much regulators may have wanted to bail covered bonds into various restructurings – as the UK government is rumoured to have briefly considered during the collapse of Northern Rock – they have so far managed to resist the temptation.

“The product is just too important for funding key areas of the economy and for financial stability,” said Ralf Grossman, head of covered bond origination at Societe Generale.

Thus, despite all that has happened in recent years in Europe, home of the covered bond, the asset class remains impervious to the surrounding carnage.

It is not the only bailout-resistant debt product on the market. Richard Kemmish, head of covered bonds at Credit Suisse, points to a few other restructuring-proof liabilities, including short-dated debt and trade creditors. But, to all intents and purposes, covered bonds remain bullet-proof and able to justify their high ratings (typically Triple A or just below).

Even when the Co-operative was downgraded by Moody’s in late June, compelling the ratings agency to warn that holders of the bank’s subordinated and junior subordinated debt would recover as little as 35% of their original investment, there was barely a whisper about the lender’s remaining £600m of covered bonds, backed by an ample overflow pool of covered assets worth some £1.7bn. Simply put, you are more likely to see Satan skating to work than to witness the default of a tranche of covered bonds.

Simply put, you are more likely to see Satan skating to work than to witness the default of a tranche of covered bonds.

Privileged position

Nor is there any outwardly visible sign that Europe, at the highest levels, is likely to tinker with this cosy state of affairs. The European Union’s Bank Recovery and Resolution Directive, set to come into effect as early as 2016, subjects unsecured liabilities to future bail-in requirements – yet exempts various secured debt obligations, notably covered bonds, from this treatment.

“The current reading of the [BRRD] suggests that the secured claim of covered bonds will not be negatively affected by a bail-in regime,” said Christoph Anhamm, head of covered bonds origination at RBS.

Credit Suisse’s Kemmish concurs. “All of the evidence so far tells us that covered bonds retain special privileges,” he said.

There are reasons why Brussels, and individual governments, love an asset class tailor-made for the lean times. Covered bonds are heavily regulated, simple to structure and operate, and transparent, a port in the economic and financial storm that continues to rage across the continent. Moreover, said Kemmish, covered bonds actually work. “Issuers like them, investors like them, regulators like them: they have continued to work perfectly through the Triple A stress scenario of the last five years.”

There are a few areas of concern. This being Europe, nothing is simple. The EU’s crisis resolution directive remains a work in progress, with Eurocrats struggling to agree on the final wording. Regulators across the continent meanwhile are also penning their own legislation: the upshot here is that regulation in, say, Amsterdam or Dublin could conflict with decisions made in the heart of Brussels. And that, some worry, could generate uncertainty over the asset class at a key point in time.

Fritz Engelhard, managing director, fixed income strategy at Barclays, warns of unintended consequences relating to this morass of new legislation. There is, he said, no guarantee that national guidelines will dovetail with pending European legislation, meaning that in the case of future bail-ins, “it’s not entirely clear that [national regulators] will always exempt covered bonds”.

The action of resolution authorities may even “have a negative impact on covered bonds”, he said. “There are potential restructuring processes or bail-ins where authorities could do powerful and unintended things to covered bond holders.”

“There are potential restructuring processes or bail-ins where authorities could do powerful and unintended things to covered bond holders”

Unintended consequences

Examples of potential hazard exist, and more commonly than you may think. The transfer of mortgage assets to Sareb, Spain’s “bad bank”, while an overall positive move for the markets, has diminished the size of the pools that back mortgage-covered bonds. Thus, only through the early redemption of retained covered bonds will some banks manage to avoid breaching the statutory minimum overcollateralisation level of 25%.

Another case involves SNS, the Dutch retail bank nationalised in February 2013. The Netherlands has a welter of restructuring laws in place that oversee covered bonds, the latest being the Intervention Act, processed and passed in June 2012.

Yet, Barclays’ Engelhard noted, had the authorities opted to write off or convert SNS’s senior debt there would have been “no legal grounds for covered bond holders to demand beneficial treatment”.

Under Dutch law, the amounts guaranteed by the body that oversees the covered pool is linked to scheduled repayments due on the covered bond itself. So if repayments were subject to a haircut under the Intervention Act, the amount due under the guarantee would shrink accordingly and, said Engelhard, “covered bond holders would incur a loss”.

Yet despite these vulnerabilities, regulators appear determined, said Marko Nikolic, head of covered bonds at Nomura, to do “anything in their power to protect” an asset class that’s lasted more than two centuries without a single default.

Passing through

Going forward, the covered bond markets faces two further, and potentially key, developments. The first is the increasingly pressing need for covered bonds backed by loans to small-sized and medium-sized enterprises.

The second is the more compellingly immediate issue of pass-through bonds. Some bankers like the premise; others hate it. “Some regulators won’t allow them and some issuers won’t want to do them,” said Nomura’s Nikolic.

Others are more gung-ho about the idea of an asset class that offers all the trappings of fixed-rate bullet covered bonds but which are immune from rating volatility. Pass-through covered bonds contain explicit provisions that outline starkly what happens if an issuer defaults, and if the cash in a covered pool is insufficient to meet a bullet maturity. They also provide a greater level of security for investors, said RBS’s Anhamm, who points to the decision by Dutch bank NIBC to issue such bonds in January.

“Conditional pass-through covered bonds may well create a new surge of activity going forward [and] become an important factor determining the direction of the market development in the years to come,” said Anhamm.

SG’s Grossman said feedback on pass-through covered bonds was generally positive. “Investors seem to accept them, and they will help issuers get higher ratings and greater rating stability.” Despite the relative paucity of new issuance this year, there is clearly plenty of power and voltage left in a super-safe asset class two hundred years old and counting.

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