IFR: The recent market turmoil resulted in a marked loss of liquidity in secondary covered bonds. In light of this, have covered bond participants been wrong to market the asset class as a liquid rates proxy?
Christian Reusch (UniCredit): I think that covered bonds are a liquid product and, even during the recent volatility, they have been as liquid as many other instruments. Market participants have adapted to the turmoil by widening the range of bid/offer spreads in market-making to ensure sufficient liquidity.
We have seen in the past that one or two banks have decided not to continue market-making. This time, the market-makers organised themselves under the ACI Covered Bond Committee and, with hedge instruments such as governments and swaps currently at wider bid/offer spreads, they questioned why they should quote a product – which is not as homogenous as government bonds – at tight spreads when the hedge instrument is much wider.
So I do think it was the right decision to triple the bid/offer spreads, but in the meantime, they have since been reduced to double bid/offer spreads. This already gives you an idea that the market has regulated and adapted itself to the current situation.
Steffen Dahmer (JPMorgan): I fully agree with that sentiment. I think the market has proved this to be a liquid product, especially in light of the fact that your underlying benchmark swaps have widened 3bp within an hour, or that you now get bid/offers in a very, very liquid swap market of 1bp–2bp. And, as Christian also said, on the govvie side, away from Bunds and other core govvies, you get bid/offers which are close to the normal bid/offers of covered bonds.
To react as the market-makers have reacted shows (a) the experience from the past and (b) the commitment of the players, issuers, et cetera to keep our product a liquid one. Look at other markets. In the ABS or senior sector, there is no market and if there was any liquidity, it was only liquidity in one or two million on both sides in a 100-tick bid/offer spread, for example.
Here, I think we have acted in the right way. After the first onset of the situation, we reacted very quickly and have now just moved from triple to double bid/offer spreads. And I am pretty sure that, after September 6th and the ECB decision and following statement from Trichet, we might have a good chance to move back to the normal bid/offers.
Going forward, of course the question will be: do we have a different new issue story or can we act in the way we did before? For example, can we price LBBW or DnB NOR bonds in the same way as we do at the moment for WaMu or other issuers that might be much more affected by the recent crisis. Maybe this is one of the points for the agenda of the ACI in the near future, so that we have a plan in place. For the time being, I have not acted differently.
Achim Linsenmaier (Deutsche Bank): The liquidity of the market has completely changed and I think that right now it is important to look at the money market first. If you don't have an existing money market curve which is liquidly traded during the day, you are virtually unable to determine forward swaps and swaps for broken maturities. And given that some 90% of the covered bond trading is done against swap benchmarks, you can't feasibly determine the exact price, even if you have a swap number in mind for that given maturity. For that reason, it is almost impossible to determine the right price and the same applies for the hedging.
Many investors have complained greatly about the illiquidity in the covered bond market which they held to be a liquid product, but I fear that they may not actually be paying sufficient attention to other markets. Look at the sovereign market, which is by definition the most liquid market. Take Italian BTPs, for example. We have seen times before where market-making has widened to three times bid/offer spreads: 10-year BTPs have been quoted at wider [bid/offer] spreads than the 10-year covered bonds were quoted in market-making.
But having said that, we also need to take into consideration that the outstanding issue sizes in sovereigns are considerably larger, be it from a couple of billion euros outstanding to significantly larger sizes of €10bn or more. You have to appreciate that we are comparing these huge issues with covered bonds which are typically €1bn–€3bn in size. So this clearly needs to be taken into account, and I think it is not rational to complain in these markets, especially in light of the fact that 95% of normal market-making works perfectly. That should be taken very seriously!
Christian Reusch: One point that has not been mentioned so far is that this time it was not originally a covered bond problem. The problem in the current market environment occurred within a different asset class, namely ABS/RMBS, and this primarily triggered the entire situation regarding liquidity.
So we cannot compare this to times when we had an issuer of covered bonds with huge problems – as we had in the past – which caused some disruption in market-making. That is one point but, on the other hand, we should also not forget that it is not the first time we have faced a situation where one market participant or another has apparently decided not to quote the bid/offer spreads.
It was only a matter of a couple of years ago when we took part in a roundtable and were discussing the subject of bid/offer spreads and how important market-making is. To my knowledge, most of the investors that have been forced to liquidate covered bonds because they had outflows in their funds or had to re-evaluate other asset classes and needed cash found a bid – and in a decent size – which clearly shows that this is liquid product.
I think the most important thing for an investor, if he has to get out, is that he gets a bid price and I think they have been served well in this case.
IFR: And to just what extent has the market widened since the onset of the volatility?
Steffen Dahmer: It is approximately in the range of 10bp–20bp for names from jurisdictions, such as the UK, Spain or the US. While names from French or German jurisdictions and from new countries virtually held their spreads.
But we have a good example at the moment because HBOS is in the market with a new benchmark, although maybe Achim can say more on the subject.
Achim Linsenmaier: We went out officially with the transaction this morning (September 4) and the deal is being marketed as a three-year issue at a spread of mid-swaps plus 5bp. This has to be seen in the context of a completely different market, however, to what we had three months ago. For example, if you look at the last UK covered bond that was issued before the summer break, which was Yorkshire Building Society’s three-year transaction, it was issued at mid-swaps minus 4bp. It basically shows that a substantial premium is necessary at the moment to bring investor confidence back into this market.
For all the reasons we have described, investors are cautious, if not scared, and it is important that something is done to reassure the market. And that is to show them that the market is up and running again and that the wider spreads are not just due to the fact that there is a certain lack of confidence but also the fact that banks are currently very much holding back and that most of the participants in the market at the moment are genuine real-money accounts. This has led to the order books, which in the past consisted of, let's say, between 30% and 60% bank accounts suddenly becoming a lot higher quality in terms of real-money participation. This basically means almost 90%–100% of the order book consists of real-money accounts.
IFR: Is this likely to be a permanent shift in covered bonds or can we expect bank investors to come back on board?
Christian Reusch: Once again, we should not get too isolated, even though this is a roundtable about covered bonds. I think what we are seeing at the moment goes across all the asset classes and, in particular, we have seen it more in the financial institution and senior unsecured markets. HBOS is one of the first issuers to come to the market in covered bonds since the onset of the volatility, and we have a certain re-pricing, at least in primary, which, of course will also lead to the result that the secondary curve will shift. At the moment nobody knows whether the level of plus 5bp is too cheap or too expensive.
In a few weeks' time, however, we will certainly know whether it was a smart idea to bring the deal at that price. If it turns out it was a little bit too wide, investors will at least have booked a nice premium. However, if the market widens further, and this it is not only a singular problem in one market, then from the treasurer’s point of view, he’s got money at the best price that was available at that time. We have seen this in the senior unsecured market. The Yankee market, for example, is already much more developed, and two weeks ago we saw around US$15bn–$18bn of senior unsecured supply. People have been paying the necessary spreads.
As Achim said, the order books look a little bit different from 12 weeks ago. We have more real-money investors, more funds and more insurance companies, which I think is quite a good signal.
At the moment, what we need is confidence. I think a lot of investors have now had their first shock by re-evaluating one asset class or another but that they are still sitting on a lot of cash. At least, that is what we observe in the market. And now, of course, they are looking for the best opportunity to make the first move: someone has to test conditions.
In Europe we have seen some senior unsecured transactions that went extremely well, like the Deutsche Bank [10-year fixed-rate], and we have seen the GE, a hybrid, that also went extremely well. The books were oversubscribed and I think nobody should complain about whether the spreads are now too wide or too tight: nobody can say at the moment. I think what is needed is properly placed bonds.
Holger Horn (Fitch Ratings): As a ratings agency, we are not so concerned about what the price for the bond is. What has struck me in the past is that market participants are failing to differentiate between products with even German Pfandbriefe being hit to some extent by the sub-prime crisis. This is interesting as, given that the product is well established, of prime quality and more transparent than other products, one would have assumed that it should benefit from a flight to quality bid. Normally, one would assume that during a time of crisis the covered bond product should come out as a winner.
Peter Kammerer (LBBW): From our perspective, I really can't confirm that view. Last week, we tapped one of our outstanding short-dated public sector transactions by €250m at a reoffer of [mid-swaps] minus 10bp, which was even tighter than its original launch.
Christian Reusch: And the deal was increased from an originally planned deal size of €200m to €250m due to the demand from investors and not just as a result of short covering.
Peter Kammerer: This convinced us that the market is there, especially for German covered bonds and public sector covered bonds
Achim Linsenmaier: What we have clearly seen in the re-pricing over recent weeks is that the differentiation between different covered bonds has really started to an extent we have not seen before.
It is an interesting question as to whether bank buyers will come back to the market. I am pretty certain that they will and it is just a matter of time. I think the main reason why banks are not participating at the moment is simply because they are holding back their liquidity for other uncertain times where they don't know how their credit lines might be affected. Once this liquidity issue is solved, I am confident the banks will come back. Nevertheless, they will probably start differentiating more between risks they like and risks they don't like. That means, in my opinion, a stronger differentiation between different assets will be made.
IFR: From this perspective, is there now more focus on the underlying credit quality element as well as the quality of the asset pool and legislation?
Christian Reusch: Investors will certainly look much more in detail into the credit and quality of the pool and legislation across all asset classes, and not only at the rating. If something is Triple A rated investors will also look into whether it is a law-based covered bond or a contractual-based covered bond. If it is contractual, buyers are likely to ask what the contractual agreement looks like. Of course, they will also look to the business model: whether it is a pure refinancing institution or whether it is more involved in commercial lending, for example. A big determination will also be whether these institutions have a proper business model that even in uncertain times allows them to pay the prices required by investors in order to take into account the current disruption in the market.
IFR: And where do DnB NOR's bonds sit in this current environment, given that they come from a new jurisdiction?
Thor Tellefsen (DnB NOR): From an issuer perspective, talking about covered bonds versus other funding alternatives, we are happier than ever that we have established a covered bond programme. Although for the time being, we are rather liquid and do not need to go into the market.
But I would think that our first step back into the funding market will be through a covered bond, and the price widening we talked about earlier appears to be significantly less for a covered bond than for a senior unsecured issue.
I do not think the market is questioning the covered bond product, although there is a lack of liquidity in the wider market. If people are going to put liquidity to work, it will probably be in covered bonds instead of senior unsecured.
Holger Horn: We don't particularly distinguish between legislation-based covered bonds and contractual covered bonds: we are more or less indifferent. However, we do see pros and cons with respect to the different structures, and it might be interesting to see how pricing works with respect to that difference. From our perspective, with a legislated covered bond one of the big advantages is that you have a good working oversight and a regulator that oversees the market: the monitoring is in some ways more transparent.
On the other hand, contractual covered bonds have some preferable features that allow us to give a better discontinuity factor, which says how far away the rating can go from the issuer's rating. These features could be soft bullets, extendible maturities, pass-through or pre-maturity tests, et cetera.
It is not necessarily that a legislation-based covered bond does not have that feature of extendible maturity, because, for example, in Germany it is not forbidden to have it, although you rarely see it. That is a feature that actually gives some comfort, because if the issuer has a problem, the continuity of the covered bond seems more likely than if you don't have it. I am not quite sure if the market prices this in or not.
IFR: In the current environment, you often hear investors say that if they don't understand something, they won't touch it. Is there an argument that there is often more credit work involved with contractual covered bonds and that investors might therefore be less inclined to hold them?
Steffen Dahmer: I would say that these days, talking to investors, they see legislation as an additional protection.
As you say, I think people are trying to invest in things they understand and this is the reason for the dried-out RMBS/ABS market. This is the reason why maybe names from jurisdictions such as the UK or Spain - though Spain is a bit different in this case - come a bit more under fire, as there are uncertainties and right or wrong stories about the residential real estate market in those countries. Is it really overheated and just how much is the likely correction?
Note, however, that the German law allows assets from these countries and one could argue that in a German fund, you could find some UK or Spanish mortgages. But I think these days people would rather prefer to invest in things they understand and any jurisdiction law helps because it adds additional protection.
Achim Linsenmaier: But you definitely raise a very fair point, which basically comes down to the fact that, when a certain number of issuers are issuing under the same legislation, it is always easier for an investor to look into that product and how it compares with respect to the underlying legislation compared to another product where they probably have already established credit lines. On the other hand, looking into structured covered bonds means that you are always looking at the product from a standing start, as one structure will differ from another.
Peter Kammerer: It is easier for investors if they have a standardised product. That is something which definitely helps them.
Christian Reusch: And there must be some advantage in having a regulation or a law in place. The UK is at least considering something which is pretty much similar to a law. But nevertheless, this gives you an idea that there must be something that makes it beneficial to have something like that in place.
IFR: So are the rating agencies wrong not to differentiate between law-based covered bonds and contractual covered bonds, especially when the latter has seen greater widening?
Holger Horn: We differentiate to some extent but, as I pointed out earlier, there are different aspects to both structures. So, for example, if you look at the discontinuity factor that we have put in place since February of this year, you can see, excluding Spain, that the discontinuity factors of the contractual covered bonds are lower, meaning better.
We believe, for example, if in Germany an issuer really gets into trouble and a special administrator comes along, he might face the situation that he sees that the next week there are some big cash outflows and he needs to liquidate some assets fast or borrow against them. Clearly, from that perspective, we see advantages looking at the contractual bonds or legislation-based instruments with prematurity tests or whatever. Although I am more or less focusing on the German legislation point of view, there are other legislations like Portugal where you have certain features also in place.
But in the end, there is a trade-off with other factors. So, effectively, the rating just looks at the credit risk in that bond. It does not look at other features like secondary market liquidity or market value. If somebody structures a covered bond and they put mitigation in place for all the risks that are inherent in contractual covered bonds, then they can achieve the targeted rating, of Triple A, for example
Christian Reusch: I take your point, but we have seen a test case in 2005 when in Germany we had a very well-known covered bond issuer, AHBR (which has since changed its name to Coreal Credit) running not only into quality problems, but also into liquidity problems.
The market, of course forced by the regulator, corrected itself by providing a substantial liquidity line which helped to solve its liquidity problem.
At the end of the day, in my opinion, there was never a reason for covered bond holders to worry. I think that it shows that if a segment is of such great importance, such as Pfandbriefe in Germany with an outstanding volume more than €900bn, in the event of default we would be discussing completely different problems.
The community of Pfandbrief issuers would clearly enter into that wider discussion, and not only by force of the regulator. What we have seen, even in these crises, is that it was and is never a question of the quality of the cover pool.
Holger Horn: I would totally agree, but just giving that example, you can see that it is exactly the point we are making. For example, the interest in the Pfandbrief market is huge so that potentially you do not get the situation of a liquidity problem from the point of view of a special administrator. And that is the trade-off.
You don't have that sort of feature and interest in, let's say, the US or the UK market. So I would totally agree. That is a very positive aspect of the German covered bond market and some other covered bonds as well.
Christian Reusch: Investors are now more inclined than in the past to say that, although it is positive to see that the covered bond universe became much bigger, the last 12 or 18 months probably did not show enough distinction between these bonds. Now, even though the secondary flows are currently small, the secondary market is showing some differentiation between A, B and C covered bonds. In my opinion this is a good development because, as is the case in the government bond sector, not everything is the same and can trade on a par with the Bund or the OAT.
I think it makes sense and, as Steffen said, people are currently concentrating on what is easy to understand and where they at least have the feeling that it is a comfortable product. Arguably, these are probably more the legislation-based covered bonds.
I am not saying that contractual agreements are wrong: absolutely not! There are a lot of positive features, but I do believe that investors have to do more credit work. They also have to dig into the single contractual agreement. In the UK, for example, there are several issuers and not everything is the same. We have hard bullets, we have soft bullets, we have different LTV levels, et cetera. So I think that would make a difference because otherwise the issuers might have decided to do everything in the same way. As it is, they have decided to add individual features in order to reflect an individual need, which is absolutely fine, but maybe one investor or another, rationally or not, might say: "Okay, this must be worth a basis point or so."
I foresee that we will come to distinguish a little bit more. We do not have one big homogeneous covered bond family where everything trades more or less within the same kind of trading pattern, and differences of liquidity and programme features need more recognition.
Click here for Part two of the Roundtable.