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Friday, 24 November 2017

Covered Bonds Roundtable 2006: Transcript

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IFR: It looks as if it is going to be another record year for jumbo covered bond issuance and that this is a trend likely to continue in the future. How will covered bond issuers reach out to new investors in this environment?

Carlos Stilianapoulos (Caja Madrid): I think there are two main ways of reaching out to new investors. One is through roadshows and opening new markets, which is a strategy that many borrowers are already undertaking. This is especially true of the Asian region, which is probably the biggest market with the most potential but, as yet, is still relatively untapped, especially by Spanish borrowers. Up to now we have not placed more than two, three or maybe four percent of a jumbo Cedulas into the region, which is a very small amount compared with other European covered bond markets. So I think there is a lot of potential in the region and still work to be done there. There is also much discussion surrounding the US market, which will also be a very important development once it eventually opens up to European issuers.

On the other hand, private placements are also likely to play a more of a significant role for Spanish borrowers in the future. Historically, Spanish issuers have not really used private placements, at least not to the extent of, say, French and German issuers. This should potentially open the door to a new investor base that up to now we have not had exposure to.

Vincent Digby (Bank of Ireland): I believe the key thing here is to maintain what the issuers have already been doing, in so much as offering a high-quality product that is very well supported and offers good liquidity. It is as much that investors are reaching out to that level of product quality as borrowers discovering new pools of liquidity or expanding investor bases.

When you create a compelling proposition, it makes it a lot more sustainable, and I think the market has been disciplined so far. It also has a long, very high-quality track record, and a combination of that and issuers working hard through travelling, marketing and continuously advancing the benefits of the covered bond to investors is what we can offer. The US certainly is an exciting prospect and, in my opinion, we would probably need a US domestic institution really involved in the market before it will get traction and hopefully Washington Mutual will be that market leader. In terms of Asia, we place as routine maybe 10%–12% of our issues in the region, but still think that is under-represented, so we still see scope in this region as well.

IFR: And what role does Asia play in Caixa Catalunya’s Cedulas strategy?

Ivan Comerma (Caixa Catalunya): It has become clear to us that Asian investors like a long-term relationship. We have not yet visited the region, although feel that a non-deal related roadshow would be a good approach for us at this point in our strategy. We have so far only issued one jumbo Cedulas transaction, so we are still missing some jurisdictions in terms of reaching out to new investors and Asia is a part of this and we still have a lot of work to do. However, what Asian investors look for with regards to a long-term relationship is perhaps not so significant for US investors. As Vincent said, we need one or two headline US issuers to approach the European covered bond market, which could lead to a rapid increase in issuance volumes year-on-year and gradually begin to open up the market for US investors. We therefore expect to see US investors prevalent in the market earlier than Asian investors.

IFR: Carlos touched there on the prospects for private placements. Will US dollars, or indeed any other currency away from euros, play a more significant role in the market moving forward?

Tammo Diemer (Aareal Bank): In the case of Aareal, we are a typical issuer that comes from a domestic market and regime where private placements are also an important funding tool. Aareal was very strong in that market and we used the jumbo structure and its positive history as a door-opener for our international issuing strategy. For example, our inaugural jumbo Pfandbrief was issued earlier this year, and this enabled us to reach out to new European investors. During discussions with these investors, in particular those in Sweden, England and Denmark, it became clear to us that there is also interest in Pfandbriefe that are denominated in other currencies. Since Aareal has a natural interest in refinancing long-dated debt in currencies than just euros, looking at these opportunities makes a lot of sense for us. The Swiss franc is on the agenda, maybe not immediately, but possibly in the future as a step in this development, and the US dollar is also a prospect for us, because we are also very active in America. However, currencies such as the Swedish krona, Danish krone or sterling is what we are planning in the more immediate term.

Claudia Vortmueller (Commerzbank): I think we have to differentiate between the jumbo market and the others. If we look at the jumbo segment, then I think that euros and US dollars will probably play the biggest role, as they have done up to now. When it comes to smaller issues, say like €500m– €750m, or even smaller deals of €100m or €250m, then I think you have the opportunity to diversify much more by moving into different currencies in a bid to reach out to new investors. So, I would say that being in the jumbo segment is more for the bigger currencies and you would need to differentiate between the two.

IFR: Jose, from your perspective are there any other advantages in tapping other currencies for issuers apart from the need to expand the investor base, such as the potential to lock into attractive arbitrage opportunities.

Jose Sarafana (Societe Generale): This is a very important strategy for borrowers, as it offers flexibility to take advantage of the conditions in other markets. Of course, the other advantage for issuers is the opportunity to place bonds with new investors, as has already been mentioned.

Digby: We all work in commercial enterprises and we are trying to do the best for our shareholders, but I would not like to give the impression that funding is purely driven by arbitrage. It is also driven by demand, and investors buy covered bonds for many different reasons to suit their own requirements. So I think, as a market, if the issuer is purely focused on arbitrage, it would ultimately be counter-productive. You have to offer good products and value for money so I think there is a balance there. I would not like the idea of private placements being driven purely by a focus on arbitrage.

IFR: In the securitisation market, it is common to see borrowers successfully reach out to new investors by offering multi-tranche structures in various currencies. Is this tranching a strategy that could successfully be taken on board by covered bond issuers?

Vortmueller: I think we are seeing signs that borrowers are taking this route already, with more and more covered bond issuers coming in with two tranches, or even three if we look at Spanish issuers. This is definitely something that I expect will continue going forward through different currencies and maturities. However, one aspect of the securitisation market is that it is not as liquid as the jumbo covered bond market and it is therefore easier to target a larger number of smaller issues at a specific group of investors.

IFR: Is it fair to say that the Spanish covered bond market is at the forefront of this development and when should this come to fruition?

Stilianolouplos: As Claudia mentioned, tranching is something we are already seeing in the market to some extent. I think one important factor of the covered bond market is liquidity and there would be concerns if we were to emulate tranches of RMBS, which might only be €100m–€200m in size and are therefore really private placements. You cannot create a proper new transaction out of a €200m issue, so many investors who would traditionally be buyers of jumbo covered bonds might not be so receptive to this type of deal. So, that is why in Spain we do perhaps two or three issues at the same time, but each issue is a benchmark transaction in its own right. We could also go a step further and do smaller transactions like the ones that we have discussed, although these would be private placements.

IFR: Does this mean that there could potentially be a problem with liquidity here?

Digby: Yes, I agree with what Claudia said earlier. I think of tranching in terms of maturities, but each tranche has to be substantially material enough to confer liquidity. If you are looking at different currencies, I believe that you are very much tailoring something to an individual investor's demands, so it is a separate private placement methodology rather than a true tranching approach to a covered bond transaction. I think there is no conflict or any instance of it being incompatible. You can have a jumbo liquid strategy, but then, at the end of the day, if our investors require particular maturities and particular currencies, they are our customers and we have to respond to that demand. I think the two work very well together.

Our strategy up to now has been to focus on the jumbo structure, the very liquid benchmark sized deals, but now we are hearing from our investors that they want us to diversify into having a proper substantial private placement capability, which needs to offer flexibility in terms of timing, size, currencies and maturities.

I therefore see this as a twin-track strategy, but would very much treat the smaller tranches as private placements coming in response to investor demand.

Diemer: It is also important to note that roadshowing with a dual-tranche issue denominated in dollars and euros would be quite an undertaking. You would have a different emphasis on a dollar transaction than on a euro issue and you would have to navigate the globe if you are marketing a double currency deal of benchmark size. I’m not sure whether that would achieve the same level of success as concentrating on a euro jumbo and maybe then, as an extension in particular for those that have dollar assets to refinance, to go for a dollar transaction with a separate roadshow and a separate focus and emphasis. That makes more sense to me in this market.

Comerma: At the same time, if you chase after two small transactions, or you do a lot of restructuring, you can eventually end up cannibalising the range of funding products that you may offer. For instance, our covered bond issuance is geared towards obtaining funds from an investor spectrum that we do not reach through our senior unsecured transactions. So, if we attempt to do two small transactions, eventually we would not be reaching those investors that currently do not participate in our senior unsecured programme. You have to be very clear in advance whom are you targeting, particularly as this is a market that is mostly in the hands of investors rather than issuers, as competition is out there and growing. You try to keep an ongoing relationship with investors and if they want a private placement, or a particular structure in one of our covered bonds, we will do that, but we have to be very careful not to put pressure on the funding mix that we have throughout all the products we offer.

Sarafana: I also believe that the multi-tranche structures we have seen during this year are also a result of the explosive growth of the jumbo transaction as a whole. There was perhaps a need by issuers, because they were funding such large volumes, to cover different maturities and currencies in order not to congest the market too much.

IFR: With these private placements and potential issuance in other currencies, are we targeting a new investor base here or is this more tailor-making new products for the existing investor base of jumbos?

Stilianopoulos: I think it is a mixture of the two. You might have some investors who generally buy your jumbo covered bonds that might have the need for a particular transaction or a specific maturity. It does, at the same time, open new potential investor bases: for example, we have seen many Asian investors in the past who basically invest in dollars and have very little exposure in Europe. Therefore, if you want to secure their business you would need to issue in US dollars, so it is a mixture of both.

Vortmueller: We definitely agree with that. It is about widening the investor base, going to Asia and trying to find new investors, identifying what their needs are and, if they are going for a specific transaction style or type, then issuing that. As far as Commerzbank is concerned, it is also very much about deepening the existing investor base because, for example, the German investor base is really significant, in so much as it already represents a very large chunk of covered bond buyers. However, you can always try to deepen it by identifying new and smaller accounts and seeing what their needs are, and then following this up with either tailor-made issues or other currencies, whatever their preferences may be.

Digby: There is another issue in terms of Asian investors in particular. In our experience, they are perhaps more comfortable with public sector-backed covered bonds, so as a mortgage-backed covered bond issuer, we have to make a commitment to getting that investor base comfortable with our product. You also have the challenge that they have an appetite for US dollar and yen issuance, which will not be the same size or have the same level of liquidity as euros. But from our perspective, this represents a new and untapped investor base, because they are traditionally buyers of public sector covered bonds.

We have had a very good experience and track record and are very comfortable with that. But, given the market dynamics going forward, there is going to be potentially less supply and high redemptions, so, from our perspective, that is an investor base that is going to have an appetite for other products and I think that mortgage-backed covered bonds are a pretty logical diversification play. I look on that as definitely a new source of liquidity for Bank of Ireland covered bond paper, because they were not buying mortgage-covered bonds before.

We spent two weeks there in the summer time and, while we had some good placement in our euro deal, there was nevertheless a clear message: they want dollars and yen, they want long-dated paper and they want flexibility, and they are prepared to accept less liquidity in order to get it, and we have to listen to that. But you do not get this investor base comfortable with a new product very quickly. You have to invest a lot of time and effort and we are happy to make that investment. So, as Ivan said, it is a long term-commitment.

Comerma: At the same time it should also be noted that private placements can be used as a marketing tool as well. Accessing the capital markets for an institution is comparable to when a private company first gets listed on a stock exchange in that every single piece of information that is revealed to the market about that company will be analysed. Therefore, having the ability to offer private placements is important because it shows the market that you are ready and capable of providing the tailor-made solutions that investors require.

Stilianopoulos: Private placements are very important because they do give you a chance of touching investors that perhaps you might not do through your benchmark deals. But I think benchmark transactions are fundamental for issuers, despite the fact private placements can be advantageous for issuers, as they can often secure cheaper funding. As a frequent issuer, you need to come to the market at least two or three times with benchmark deals and, once you have done those, then you can begin to focus on private placements. But you need to be constantly in the market. In our case, we have never done private placements in the past because we have concentrated all our Cedulas, or all our mortgages, on benchmark issuance. Now that the mortgage market has grown so much in Spain, we also have room to do private placements, but it important to do benchmarks first.

Diemer: Vincent made the point that it would be a natural progression for investors that had invested in public sector assets to now turn their attention to the mortgage-backed market. I think the reason is, to an extent, that these public sector-covered bonds are able to provide investors with a very internationally diversified cover pool in various countries and jurisdictions. There is also a trend from property banks that are issuers of mortgage Pfandbriefe, where their internationalisation strategy is also reflected in their cover pool. Aareal is a good example of this, given that we have a fairly international cover pool that would support this argument for diversification into mortgage-backed assets by investors that have traditionally been more interested in public sector-backed bonds.

IFR: One headline development this year has been the expansion of the European market to include new jurisdictions, as new legislation is passed. In terms of the jumbo structure, will the diversity play continue to drive investor demand going forward?

Sarafana: When a new entrant comes to the market, it generally commands strong interest from investors as it provides an opportunity for portfolio diversification. Therefore, new covered bonds out of markets such as Sweden, Portugal and Italy should enjoy a positive reception from investors. Moreover, another important factor is the Capital Requirements Directive framework, a comfort zone for the investor who knows that he is buying a safe product that offers the opportunity to diversify. We expect demand for covered bonds out of new jurisdictions to be good.

Vortmueller: I would agree with that. What we are seeing is that investors are very interested in new products and in new names. It is definitely easier if there is solid legislation in place, like we are seeing in Sweden or Portugal for example: this is certainly an advantage. But we are also seeing growing demand for products where there is no legislation in place. The UK has taken the first step in this respect and we are also seeing additional countries and new products, such as the US. Investors are definitely keen, and while it would be an advantage to have legislation in place, the product has been marketed so well by issuers and banks that it is generally becoming more and more attractive.

IFR: How will the introduction of these new jurisdictions impact spreads of established markets such as Germany, France and Spain?

Stilianopoulos: I think that the impact on spreads will be negligible, as the expected issuance volumes of the new countries will not be significant enough to have a major impact. I think new issuers coming to the market will obviously have to pay a small premium, which will be corrected in the following months, as soon as the market becomes more mature.

Ultimately, I believe that spreads are a consequence of not only your own legislation or jurisdiction, but also of the amount of issuance that comes out of your country. In the case of Spain, we have so much issuance coming to the market, and this is reflected by our need to pay a pick-up over other countries that perhaps are not issuing as much. The reason behind this is largely down to the extent of competition within our own market. So I do not think that the new entrants will affect outstanding spreads.

Digby: I think new entrants could actually help the overall growth we spoke about earlier. As has been pointed out, there has been very strong growth and heavy issuance out of Spain, which has been a very dynamic market, while in the Pfandbrief market in Germany, we have seen a bit of consolidation. If you are on the buyer side, you are faced with a concentration of issuers and, even if you are happy with the product itself and you like it, you would still want to have opportunities to diversify and rebalance your portfolio. New names and legislations help portfolio managers reduce this concentration and I believe that this will ultimately lead to higher overall holdings of covered bonds. This would be a very positive development because too much concentration will restrict growth.

Comerma: Apart from Germany, France and Spain, there are few investment opportunities, so there is definitely a problem of concentration. We know the market still runs high on liquidity and as long as investment portfolios grow as new jurisdictions are added, investment in Spanish issuers should grow proportionately as well. In terms of spread, I believe that Spain offers a very interesting and appealing spread for investors compared with other countries. The real estate market has been the main driver for Spanish institutions' balance sheets, and we are now seeing signs of a slowdown, or at least a soft landing within the sector. While we still have positive growth, in our opinion, the market has now reached its peak. This, in turn, should help in terms of portfolio rebalancing with the newcomers, and eventually lead to a lower degree of net issuance from the Spanish market.

Digby: There is also a challenge on the other side of that equation, as the newer, smaller borrowers from these jurisdictions would have to tap the market on a large enough scale with sufficient supply to make it a viable proposition. If credit analysts are going to invest their time and do the research, gain credit approval and then maintain it, they should rightly expect a good supply of product. So, for the smaller markets, we do need a certain scale of supply for them to claim their spot.

Diemer: Adopting a legislation is one thing but, in the end, pricing and the performance of the covered bond market also hinge on the supply and demand situation. For example, due to the strong growth in the Spanish mortgage market, there has been a great deal of supply from Spanish issuers, which has caused a differentiation between market segments. Therefore, I think that it is not so important whether there is a particular advantage of one legislation over another, it is more a case of the supply and demand dynamics and how you treat the capital markets.

Stilianopoulos: While the Spanish mortgage market has recently grown some 20% or more year after year, the supply of Cedulas this year will grow perhaps only 10% compared with last year. This is a trend that is developing because, as issuers, we do not want to keep on issuing covered bonds or Cedulas, as we do not want to dump paper on the market. We are trying to look at other instruments to use, which is why the RMBS market is also growing, as we begin to switch our mortgages into RMBS instead of Cedulas.

Sarafana: The new legislation also has an effect on the demand side in so much as countries that have been restricted from buying covered bonds in the past will now have these restrictions removed. One example of this is Italy, where, while not yet fully in place, the second draft of the Bank of Italy regulations constitutes a lowering of the risk weighting for Italian investors to 10% from 20%. I would also expect to see the same in Portugal, so we will see not only diversification through the new covered bond legislation from the issuing point of view, but also from the demand perspective.

The risk weight thing is very much a tit-for-tat game between some jurisdictions that say: “Okay if you give a 20% risk weighting to my covered bonds, I will also give 20% to your covered bonds." However, as legislation is introduced, these nations will want to issue bonds and then their strategy will be: "Okay, in order to sell our covered bonds at a low risk weight, we have to accept other covered bonds for our own investors also at a lower risk weighting." That opens up the market in different jurisdictions.

Comerma: At the same time, if we are touting bonds to new investors, such as those in Asia and the US, they will be looking for liquidity rather than diversification, as they have not been investors in covered bonds up to now. The introduction of new markets would therefore put some pressure on the more mature issuers from Germany France or Spain in this respect.

IFR: Will the introduction of new jurisdictions offer investors more spread differentiation and will there be opportunities to play the relative value game once these countries enter the market?

Vortmueller: One of the aims these new issuers have, of course, is to gain a very efficient funding tool and come as tight as possible and, while they might be willing to pay a little pick-up, I am not convinced that they will be overly generous. But in terms of relative value, I think that the market is getting rather tight as differences between the countries is not that significant. The obvious exception to the rule is Spain and Germany where there is a sizeable difference, but that is due to the different volume of issuance, as we have discussed.

You have a lot of issuance out of Spain and therefore the Spanish issuers pay a pick-up, but with the new legislation, we definitely have to see how that will pan out, as the universes are completely different. For example, French issues are quite expensive, as there are only three issuers in the market and the legislation is regarded as very safe. Therefore, they come at very tight levels and sometimes – I do not want to say opportunistically – but they do try to find these windows of opportunity from time to time. The German market is also rather tight, and then you have other markets such as the UK that has a 20% risk weighting, and that again is reflected in the premium that they have to pay. Nevertheless, overall I think that the room for spread differentiation is really quite limited, as issuers will try to fund as efficiently as possible.

Diemer: And in line with all new legislation, borrowers are striving to successfully open up a Triple A rated environment for their own funding needs. Part of that entails ensuring that the product that they offer mirrors the quality of comparable products in the same asset class in order to secure the Triple A rating. This, in turn, is positive for the growth of the market in general, as it would enlarge the universe of high-quality, liquid bonds.

Comerma: It is quite obvious to see that the market is looking for diversification and this is well reflected by secondary market spreads that look tight from a relative value perspective. Therefore, the market price is often distorted in the early stages of the life of the bond and this makes it extremely difficult to assess exactly what is a fair trading level for these issues. I think that the outlook and development of these markets will be very interesting.

IFR: In that respect, would it be correct to say that diversification is going to take precedence over spread?

Sarafana: I think investors will look closely at the rating of the issuer, but the legislation will also be considered in this. For example, when the Portuguese constructed their law, they were obsessed with implementing a very solid law that was somehow better than other established markets, and now we have to see whether this will be reflected in spreads. I personally think that this is a very safe example of a covered bond law and will be reflected in the pricing of the first Portuguese covered bonds.

Diemer: Well, on the one hand, investors continue to reach for diversification opportunities, although each new jurisdiction has different legislation. Investors have to take this on board by studying each law, working through it and starting a new product process. We do not have the luxury of having a common covered bond law throughout Europe and this is a scenario that is not going to change, and is therefore something that we have to live with.

Vortmueller: And if we had a uniform covered bond law in Europe, it would obviously take away diversification, would it not? So, while it is more cumbersome and sometimes consequently takes more time to analyse the laws, it is definitely worth it for investors.

Digby: I think the key trend here is the compression of the spread between the issuers that has gradually compressed over time, and I think that this is appropriate. It is a Triple A product and it is very secure after all, and I think this is a trend that will probably continue unless, of course, there is some very significant event that challenges the perception of Triple A product being very secure.

In terms of new legislations, I think new issue premium is appropriate for people to invest the time and effort and is very sensible and practical. There has been a lot of focus on the legislation, but annexing your domestic market can have a bigger impact. If you have a traditional investor base that likes, and is comfortable with, the domestic product and is willing to give up some spread for that reason, that is their investment philosophy and decision.

But I think over time – and this ties back into the bigger theme – that more domestic investors will begin to diversify and therefore you will see a balancing out of this. You will have, maybe not a pan-European covered bond law, but possibly a pan-European covered bond investor base rather than pockets of significant domestically focused investor bases. That is a very long-term trend, which supports a compression of spreads in general. Within that, I think there not being a single covered bond law is positive for the market and for investors, because we will all compete furiously in terms of features in our legislation, and also over-collateralisation and loan-to-values. I think that will be a very positive dynamic in the market.

IFR: Would you expect Washington Mutual’s debut jumbo covered bond to set the ball rolling and encourage other US borrowers to come to the market? And if so, once the market is established, do you think that this could eventually open up a new investor base in the US for European issuers?

Sarafana: For me, the key point is the currency that US investors traditionally invest in and this, of course, is US dollars. As a result of this, I think, at least in the initial stages, it will be US institutions solely targeting the European investor base with new issues. I also believe that Washington Mutual will be forced to pay a pick-up for its inaugural issue, given that it will not be covered by the Capital Requirements Directive coupled with the fact that the US real estate market is taking a turn for the worse.

Vortmueller: I have been studying the concept and I would agree. The rating agency reports have now been released and, as Jose said, it does not comply with the Capital Requirements Directive, it does not comply with UCITS. So, in my opinion it should have a 20% risk weighting. Also, if you look at the structure of the cover pool, you have quite a bit of concentration in there, as Washington Mutual is almost 50% Californian residential properties, which also leads me to believe that they will definitely have to pay a pick-up. I would consider it should price more in the region of a UK covered bond and could possibly even offer a small premium compared to that market.

It is definitely a very interesting development and I am pretty sure that European investors will be very keen to look at it. However, the prospect of opening a dedicated US investor base [for European issuers of jumbo covered bonds in euros] is still wishful thinking at present because we really need to see how many US issuers will follow Washington Mutual to the euro market. Following that, there is then the question of whether US investors will accept covered bonds denominated in dollars and issued by household US names. Once this is established, US investors could then begin to buy a European product that is denominated in dollars.

IFR: And would you expect Caja Madrid to make inroads into the US market anytime soon, Carlos?

Stilianopoulos: Perhaps not soon, but we have to be ready, and we are really beginning to look at the US market. We have never issued before into the US and this month we are roadshowing an extendible transaction from Caja Madrid and hope to follow this up with a senior unsecured transaction either in November or January next year. This will give us initial exposure to US investors so they get to know our name and our credit story. This should get our foot in the door and then, should the market open, we will be ready to do something more significant. For us, it is fundamental that the US market investor base opens for European issuers, as this would immediately solve a lot of our problems.

Comerma: It has been three years since HBOS issued the first jumbo UK covered bond and there are now plenty of UK borrowers that have successfully followed in its footsteps. I think this is a good proxy for the development of the market for US issuers and, in my opinion, it represents a solid starting block for US investors to branch out into euro-denominated bonds issued by US institutions.

Digby: I will watch the transaction with great interest and hope they get the appropriate price and it is a great success. I do not think you are going to fundamentally crack the US market until you get the US investors really focusing on the product, and the best way to do that is to have US issuers issuing in dollars. I think it could be one of the most fundamental developments in the covered bond market.

As Carlos said, you cannot sit and wait for that to happen. It is going to take time and other issuers will have to follow and issue in Europe in the core market of covered bonds and then decide to try and spread the gospel to the US investor base. To date, they have not shown any particular interest in the product, but that has happened in other areas as well and you have seen a move away from an RMBS mindset into a covered bond mindset.

So I think it just needs momentum for that to happen, that and supply. But you also have to do your credit work now. You cannot turn up in the US with covered bonds and an unfamiliar name. I think the European issuers have to be prepared, but I am very excited by the prospect and I hope it goes very well, because if it does not go well it will be a significant setback to the market generally.

Sarafana: I am somewhat more sceptical about US issuance in the future because, unlike the UK, the US does not belong to the European Union and therefore does not quality for the same treatment under the Capital Requirements Directive. So we will then have a market including the UK that is supported by the Capital Requirements Directive, and others such as the US, which will not profit from the Directive and the advantageous risk weighting.

It then has to be seen whether investors will demand some kind of premium that reflects this. Either way, the UK and Netherlands will implement a law in order to be compliant with the directive and benefit from the lower risk weighting. If US issuers do not have that opportunity, they will have a disadvantage that others will not have.

Diemer: Well, I think the first aim for Washington Mutual is to open up their product to European investors. If and when US investors become interested in a dollar-denominated covered bond, then I believe the real potential to benefit will be established.

Vortmueller: If I am right, I believe that Washington Mutual intends to not only utilise the covered bond structure to broaden its investor base within Europe, but also to actually lengthen the maturity of the bonds that they issue, and I think that this is one of the key reasons why it might pay off for them. Even if they do have to pay a premium compared with other markets, they would still be able to issue longer-term transactions and investors should be happy to buy the bonds at levels that offer a good premium.

Digby: Do you believe the ultimate objective is to open the domestic investor base to the product or to diversify into Europe?

Vortmueller: To diversify into Europe.

Digby: I would have thought that, while there are obvious advantages of expanding the investor base into Europe, the real gain for Washington Mutual and other US issuers would be the potential to open up a dedicated domestic US investor base for its covered product.

Diemer: But then you would be in direct competition with the mortgage market, which has already well established there, and has been for many years.

Digby: But in terms of the structure, you are currently looking at the US mortgage market in terms of having mortgage originators that go to the agencies. This contrasts to what you have in Europe, where mortgage lenders can finance themselves through the covered bond market: ultimately, which one is the more efficient structure? I think there are attractions to the European model and that is beginning to get some exposure into the US. I therefore believe that we could see more of a profound change in the US rather than the headline development being just this issue reaching out to European investors.

IFR: The sticky subject of liquidity is a perennial topic in the expanding market. Do the jumbo criteria as they stand still confer genuine liquidity?

Vortmueller: If we consider the German market that originally introduced the jumbo standards that have since been adopted by other European countries, then these jumbo standards for Pfandbriefe market making have recently been amended, and I think that this is very positive step. For example, the number of market makers has been increased to five from three, while prices now have to be made in normal market hours and that has been defined from 9am to 5pm. In addition, we now have a dedicated committee where market makers and issuers meet to find solutions and see how liquidity can actually be maintained should the market face another crisis like the one we saw with AHBR and that triggered this rethink of jumbo standards in the first place. I think these discussions will be an ongoing process, but we are moving in the right direction, not only by trying to tighten the standards and the commitment from the market makers, but also on the deals themselves.

Sarafana: An issue can be illiquid simply because it has been well placed and there is little turnover, which in turn raises the question for the borrower whether to tap the bond in order to make it liquid again. Regarding the new jumbo standards, I am more sceptical whether they will work for two reasons. A bond becomes illiquid simply because the issuing bank or company has some kind of problem. If there is a market-making obligation, this raises the question that if everybody is selling these securities, does the market-making bank really want to buy, despite the fact that they have signed the market- making obligation.

I am unsure that this is going to work, as participants will prefer to wait for more information and this would throw a spanner in the market making process very quickly, as we have seen on many occasions in the past. Also, there are no sanctions taken against the market makers that fail to adhere to their obligations in the face of a crisis, nothing that forces them to buy bonds if there is a problem with a certain issuer. I therefore have serious doubts as to whether the new system would work should another problem with an issuer arise.

Vortmueller: It could definitely be difficult, but issuers could introduce their own sanction mechanism. For example, they could decide not to accept a particular bank as a lead-manager in future transactions if the bank ceased market making in two or three cases when things became difficult. Is this not something that could be considered?

Stilianopoulos: Yes, but if one bank stops market making it would not be the only bank, as others, especially those doing the same transactions, would say: “if they are not making a market, then why should we?” and then you would be left with a number of banks in the same situation. I agree that there is a way of forcing it, but how far can you go as an issuer?

Digby: When liquidity is fine, market making works perfectly well, and then something happens and it stops completely and, as Carlos pointed out, once one stops, every firm in the street stops as well. So, rather than having a committee, I think it should be graduated, depending on the volatility of the price spread. Then you are not compelling people to take what will be at the outset a potential loss, or a negative credit position, but they are getting compensated as the volatility increases and the prices that they have to commit to are widened.

I think issuers should then demand discipline, because you are not compelling the market makers to take uneconomic action. I am also rather sceptical as to how much selling actually materialises from end investors. They will want to know what the price is of course, because their credit committee will want to know what is happening in that bond, but that does not mean they are going to turn around and sell.

If I were on the buy-side, I would say to issuers that our liquidity cannot be binary: create a structure or process whereby we get liquidity, albeit in different spreads and different levels under different conditions. I do not want to compel investment banks to take an uneconomic decision and they should be rewarded for the risk and that should be graduated. We do then have a responsibility to say if someone does put their best foot forward and stands up to their commitments, then we as issuers should reward and acknowledge that in the future flow business.

Stilianopoulos: I agree. Because banks do not earn money during the market-making process, instead they might earn their fees at the beginning of the transaction and that is it. In tough conditions, they could actually lose a lot of money, so it is not easy to reward these traders in order to ensure they do maintain market making.

Comerma: The wise thing here is to be as market maker-friendly as you can, because there are few good market makers that disclose what they are doing with your paper and they do not want to feel that they are the only ones supporting the bonds.

As has been mentioned, liquidity is not binary and from an issuer’s perspective the wise thing to do is to maintain an ongoing relationship with market makers, which also helps the issuer get hold of valuable secondary trading information.

Diemer: The European covered bond market is the most liquid bond segment after the prime government market. Standards are very high with a high-quality framework and have actually been improved recently by the Association of German Pfandbrief Issuers [vdp], as Claudia pointed out. Taking the view of an investor, I feel very comfortable with market making, and repo trading as an extension of this also works very well. A jumbo remains liquid as long as some investors give the bond back to market makers via repo. Some funds do this to earn an extra yield on the bond, which simultaneously supports the market making.

IFR: Jose, you expressed some scepticism concerning the recent announcement on the market-making standard. What, then, should be the alternative, and how could liquidity be improved?

Sarafana: Overall, I think Tammo is right with his suggestion that liquidity is very good, particularly in the recent flow of issues, but it is still lacking in some older bonds. One way to address this is for issuers to tap older transactions more regularly in order to increase the share of freely available bonds that are actively traded. As you said, I am still sceptical on this new market-making commitment and cannot see how it will be respected if a trader or the credit department of a market-making bank identifies a problem.

Stilianopoulos: I think we have a problem with taps, because generally older issues trade at tight levels in comparison to what the primary market expects. If we have an issue that is trading at, say, mid-swaps plus 2bp, a new transaction would need to come to the market at, say, plus 6bp. What then happens to holders of those bonds who own them at plus 2bp? This is something we have looked at in the past with some of our issues. Some investors do prefer you to increase it, but others do not want you to, so it is difficult because there are few issues that are trading around the primary level.

IFR: In which case, Carlos, at what point does a formerly liquid issue become illiquid?

Stilianopoulos: I guess it becomes illiquid once it is placed 100% with end investors: you do need the banks to move the issue around. Perhaps 10% of the issue has to be in the hands of traders in order for it to get moved around and for it to get sold.

IFR: Could it not be said that volatility divided by the amount transacted is the best way of accurately measuring liquidity of an issue?

Digby: I do think that liquidity is an imperfect situation. While I accept the point that it works very well 99% of the time, we are trying to position this product to ensure it is there 100% of the time. I think liquidity has to take volatility into account, and if there are any dramatic price movements, then liquidity requirements for the market makers should reflect that and be graduated, but it should always be there at a price. Older issues and tapping is a potentially thorny issue, but I think it depends on the issuer's communication at the outset. You have to be upfront if you do intend to tap and it is your responsibility to ensure that it is genuinely an investor-driven exercise. At our institution, we would be cautious about jeopardising performance for the sake of extra liquidity. If a bond is well placed, has performed well and investors are satisfied, I find it hard to quantify the extra benefit that additional liquidity will offer against the potential risk of losing performance.

Comerma: Well, as Carlos said, trying to address the covered bond market is a long-term commitment, so we prefer to let market makers decide if something is liquid and whether they want to make a market or not. Our role is to continually provide benchmark transactions that allow movement from one to the other, and end investors will inevitably decide which issues they trade. As we have mentioned, we cannot force market makers to perform, as there is no punishment for them if they do not carry through their obligations. All we can do is be transparent and show we are here with a long-term commitment, as covered bonds are fundamentally a very important funding vehicle for us.

Digby: Also, new issues can sometimes free up liquidity if things go back on switches. So, if a deal has been well held and it is coming towards maturity, but a new issue comes out, you can sometimes free up paper and you get more trading and liquidity out of it that way

IFR: Recent statistics suggest that around 40% of jumbo covered bond trading is now executed over the electronic platforms. As the minimum issue size requirement over these platforms is often €1.5 billion, is it fair to say that the current €1 billion minimum jumbo criteria should be increased to reflect this?

Stilianopoulos: Probably, yes. I think €1 billion might be liquid for the first month, but will often become illiquid in the short to medium-term, depending on various factors, such as maturity and what type of investor is behind it. For example, a €1 billion 20-year deal will become illiquid very soon, whereas a five-year will remain liquid for longer. But I do believe the electronic platforms are one of the best resources we have in the market to enhance liquidity, so transactions should be large enough to be included. However, issues that are large enough often do not have enough market makers who want to give prices. We have around 30% or 40% of our transactions traded over the platforms and the other 60% are not traded, even though they are big enough to be included.

Digby: I cannot say we have seen specific demand for this electronic platform eligibility, but it is a feature we try to offer, as we feel that having an electronic platform is one of the better ways of achieving liquidity and also tracking it. You get your statistics every month and can see who is making prices, who is not, whether it is coming from real end-investor demand or flow, and where the flow is coming from. We will also sometimes test our market makers by getting a friendly investor to call up and ask for a price. We do not pay too much attention to the price spread but rather the speed of the quote, which will tell us whether they are actively looking at the issue or not.

We always say to every investor we meet, if there is a better way to monitor or ensure liquidity, then we would like to know about it. We also acknowledge banks that make market in our bonds but are not on the transaction and take this into account when rewarding new mandates.

Diemer: I think smaller issuers add value to the market, as investors reach for diversification, and it is the smaller issuers that can provide that. From Aareal's point of view, we have funding needs that can easily be covered by private placements and long, targeted instruments, but we also provide a jumbo on average once a year in order to diversify our investor base. Other issuers, such as Sampo Bank, came with its first Finnish covered bond last year and that has remained very liquid. I am therefore quite sceptical whether the size of the issue and liquidity are necessarily the same thing. At the end of the day, if you are short of a bond and you cannot get it then you will say this bond is illiquid, but many of them, such as the one I have mentioned, are perfectly well received in the repo market.

Comerma: We are still relative newcomers to the covered bond market but we are continuously talking to market makers and trying to target new investors. The way we wanted to approach liquidity was through the repo market by suggesting that investors should be long or short regardless of where the spread is. We achieved this by signalling that we would designate some part of the transaction just for repo so we could give priority to market makers, and it worked. Today, with just one transaction of €1.7bn in size, we have more than 10 market makers actively trading it, which underlines the fact that the repo market is key.

Sarafana: I agree that the key point is to what extent there is liquidity in the repo market and whether the bonds can easily be obtained. That is a technical issue and if the repo market remains sufficient, then it can be said that liquidity in the bond would be maintained.

IFR: Earlier, we touched on the vdp’s recent announcement of new market-making standards. Do you think other covered bond jurisdictions have a duty to follow suit?

Vortmueller: I think if we really look at the jumbo segment as a whole, a European-wide agreement would be the optimal thing, where we could then say that we have one jumbo standard, or one market-making commitment throughout the whole region. Whether we will ever be in a position to implement this, I do not know, although I believe that harmonisation with regards to trading would be a positive step forward in the interim.

Digby: I think, in terms of a pan-European consistent approach, maybe under the stewardship of the ECBC, for example, they could adopt a market making committee that could help transparency and consistency. I still hope that sometime we will tackle that one percent issue [when market making falters], which I think is the real concern around liquidity when it is not working. However, there would be if there were a dedicated committee that could communicate that market making has now ceased in this bond. You would then get more transparency, which is currently lacking for issuers and investors and limited to bilateral conversations and communication. But I am not sure if it will ultimately add anything to underlying liquidity.

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