Covered Bonds Roundtable 2007: Part 2
IFR: From an issuer’s perspective, how important is it to you that traders continue to make markets in your bonds?
Thor Tellefsen: What we have been hearing all the time from investors is, of course, that market-making is extremely important. I think that, going forward, as an issuer it is important when we are choosing a lead management group that we are certain that they are willing and able to fulfill their market-making commitment for as long as it is possible.
We do, of course, understand that when there is no swap quoting, it is complicated to market-make, but I think there is clearly a difference between totally shutting everything down and between trying to do as best as you can.
Peter Kammerer: I agree. We are not only an issuer; we are also a market-maker in LBBW and other covered bonds as well. Market-making is important for covered bonds: as we mentioned, it is a liquid product and market-making underlines this. It is the liquidity that is one of the selling points of covered bonds when speaking to investors, and we have seen the market react very well to the crisis.
As mentioned before, we have had difficulties in the swap market, in the money markets, and even widening spreads in the government bond market. Therefore, we are fine with how the covered bond market handled the situation. I am sure that once we have seen the first issuers coming to the market, confidence will start to return and we will hopefully see the situation normalise.
IFR: I have spoken to traders over recent weeks that have stopped head-to-head market-making altogether. Have you witnessed this and is this consistent with the arguments for market-making?
Steffen Dahmer: In this market turmoil there were indeed a few houses that temporarily had bigger problems than others.
IFR: Like picking up the phone, perhaps?
Steffen Dahmer: Yes, maybe they had not paid their phone bill! So, yes, indeed a few houses were difficult to reach for a period of time for checking bonds, but at the moment I have the feeling that the whole community is back on track and is doing its job. As I said, it was for a short period of time and only involved a few houses that maybe had an internal communication problem.
Achim Linsenmaier: I think that market-making should be taken very seriously and this is due to the fact that we normally aim to place bonds with accounts that otherwise typically go for more liquid bonds like the sovereign or the agency issues. These accounts, at least the big players, expect to have liquid trading opportunities in good size. As everybody can easily see without having to look in too much detail, a €1bn or €2bn covered bond can never compete with an agency of €5bn or a sovereign of €10bn size just through its own natural liquidity.
Therefore, I think that market-making is extremely important, even if some people complain that it is just artificial liquidity. It is not. As for the market-makers, if the bond is not available, simply price it tighter until there is a balance again. From my point of view, it is so important to have this market-making in place and to stick to it: otherwise we will lose a lot of the investors.
As an example, about five years ago we had intense discussions with some international investment banks that were not too keen on market-making in the German sub-sovereign space, and they went back to issuers and told them: "This market making is an old domestic German thing and you don't need it". One or two issuers started issuing bonds without a market-making agreement and then they realised about a year or two later that they had hurt themselves. Suddenly, their old bonds that were still under market-making agreements traded about 2bp–3bp tighter on the curve than the new bonds that were launched without market-making agreements.
As a frequent issuer, you will be always measured by your existing curve, which basically means issuing covered bonds without a market-making agreement means issuing at wider levels because investors want more illiquidity premium.
So it is in all market participants' own interests to have this market-making in place. It helps investors to have a liquid market and it helps issuers to be able to rely on their existing outstanding curve which is liquidly traded.
IFR: Even in the current environment? I spoke to a trader recently who asked why he should be expected to market make €15m of bonds in tight bid/offer spreads when, in a wider context, central banks are having to inject liquidity.
Christian Reusch: There are several points to be mentioned. First of all, I do agree with Achim, it is not purely a German affair, as some journalists try to insinuate. A lot of international players have done a proper job in this turmoil by providing liquidity.
On a recent conference call of market-making banks, roughly 30 participants were on board and the majority agreed to conduct market-making on widened bit/offer spreads. I think this is something that is worthwhile noting.
Second, I could probably understand if one or the other made the decision not to make markets for whatever reason. But why not then inform all the participants on the call? If there is a problem, the trader needs to openly state it. It may not be right, but at least it would be an open and transparent dialogue.
Another point we should also not forget is that having more volatility does also offer opportunities and creates possibilities to set up trades to make money. In these markets you can make money. By providing liquidity and by being a consistent partner for your investors as well as market participants you can also gain something: it is not just about losing. While there certainly can be a downside, there is also an upside.
Achim Linsenmaier: And this does not take into consideration the fact that covered bonds are typically ECB eligible and can be pledged to the ECB to get liquidity. It is therefore not something that can be compared with senior unsecured liquidity – which is tough to get in the market at the moment – because covered bonds can be used as collateral.
Steffen Dahmer: Talking to investors, I have been told that the reason why covered bonds are traded tighter than ABS or RMBS, for example, is liquidity. So altogether, issuers, salespeople, market-makers and syndicators all have to be aware of this and have to take it into consideration.
The majority of participants have done their job properly, though there were a few that temporarily did not understand the reasons why we were keen to have the whole community on board [in market-making], which is because, going forward, it will make sure that investors remain invested or continue investing in covered bonds.
I think the marketing of Pfandbriefe from representatives such as the vdp's Dr Louis Hagen is important, and the fact that Pfandbriefe are well established is perhaps one of the reasons why they have reacted so well to the volatility. But the market-making and liquidity and size considerations are also important for a flow product.
According to the headlines, Mr Steinbrueck (German finance minister), has confirmed that he will have a surplus this year, and the supra, sovereign and agency market will remain unchanged in terms of size. Therefore, the only market that can generate these kinds of sizes in the future will be covered bonds. So the importance of covered bonds is huge and the commitment of everyone should be there.
IFR: But will investors ever regain complete confidence in the market?
Peter Kammerer: Bringing good working deals is of the up-most importance. We have discussed market-making and commitment but what now needs to be done is for issuers to continue to tap the market so that we see the deals working. I am sure that investors will then come in.
After today, I think we will have a better view about the market and hopefully the [HBOS] deal will go some way to restore confidence. Investors still have money to put to work, and now that they have gained more confidence in the government market, the next step will be the covered bond market.
Thor Tellefsen: I think what we can do from DnB NOR's side is to actually go out and tell our story, because it is imperative that we get confidence back and that investors understand that this is a safe product.
In some way, I think one problem we have in the market today is that having a Triple A rated bond is not the same as before the summer. There are some bonds where investors are questioning their Triple A status.
So the mandate we have as an issuer is to go out and tell our story to convince investors that DnB NOR covered bonds are a strong and a true Triple A covered bond, and hopefully investors will trust us on that.
Peter Kammerer: What also helps is transparency from issuers. If you have showcased your covered bond, then you get information out there about how it works and what it is. That will then bring in additional confidence and support from investors.
Holger Horn: I think what is also important to remember is that a Triple A rating does not necessarily mean that you have a liquid bond or tell you what the market value of the bond is. It is just about the PD (probability of default) of the bond: it is nothing more.
I think that the market has slightly misinterpreted what Triple A means. We have received calls from investors asking how it can be that a Triple A they bought yesterday is worth less today. That is not a question of being Triple A or not, and I think that is important to understand.
Steffen Dahmer: To restate one thing: we are not talking about a covered bond crisis. A few market-makers being temporarily absent from the market is not important, nor does the fact that investors are differentiating between Triple As or different jurisdictions. We are in a liquidity crisis. This liquidity crisis will hopefully be over soon but there is still a lot of uncertainty and, as long as we have this uncertainty, we will have difficulties.
I agree with what Achim said: that there is a lot of liquidity in the market, at least with the investors. At the moment they prefer to retain their liquidity, because they don't know what is going to happen next. When this risk and uncertainty is over, I am pretty sure they will invest and that covered bonds will be one of their first choices.
Christian Reusch: Absolutely right: we do not have a covered bond issue. But I do think we need to bring more self-discipline into the market-making community, because personally I think – and this is also what I have heard from several issuers – it is a little bit odd to say: "I would like to be a bookrunner on your transaction, I would like to take the primary fees, but if the market is not plain sailing anymore, then I will immediately forget about the obligations I signed when I got the mandate."
Primary fees are paid for the whole operation: be it research, be it syndicate, or be it trading. So, at the end of the day, if you get a mandate as a bookrunner, part of the deal is doing a proper market-making job. I think this is essential, and most market-makers and also a lot of international houses have done an excellent job and have been very good in managing the situation, even though one or two decided not to be part of the active market-making community anymore.
IFR: Some traders have argued that the tripling of bid/offer spreads was implemented a couple of weeks too late. Is there any truth in that?
Christian Reusch: Well, I guess one trader or another might always find an excuse. Why do these people or institutions not address their concerns to the market-making committee and say that they have something to discuss?
The solution cannot be just sitting on the sidelines and then complaining about something that they take advantage of in normal times. They also have to bear the consequences if something goes wrong and, if it does go wrong, everyone should be professional enough to ask what can be done. We have emails, we have telephone lines, so it is not as if we are living in the 18th or 19th century when we had to send letters which took two or three days to arrive by mail. We can find quick solutions.
IFR: Looking at the re-pricing of the primary market, why has a UK covered bond from HBOS been chosen as the first jumbo to be launched since the volatility began?
Achim Linsenmaier: I think what is important to take into consideration when one is looking at the primary market these days is that the market has changed completely in comparison to two or three months ago.
A few months ago you could more or less determine where a new issue should be priced spot on to the last basis point. This certainty meant you could go out with a reasonable size and reasonable guidance for a transaction, and you could almost guarantee that this transaction would be a success.
These days, the market has changed significantly. As everybody has already agreed or mentioned, there is a lot of uncertainty and it is quite important to take away part of this uncertainty. Therefore, one really needs to look into how investors act these days.
Many investors are having significant problems with positions they are holding. Sometimes this does not have anything to do with covered bonds at all, it is just their overall portfolios, but there is so much uncertainty in the market that people simply need to be convinced to take part in an issue. Therefore, I think it is important to have primary issuers coming to the market with transactions that are priced to sell, especially in the first instance.
The market has changed to the extent that these days investors will let you know whether they are happy to buy in principle but you can't tell them any more, Before, it was a case of “this is the secondary market, recent issues have priced at this level and this is fair value, you can buy it." These days they will tell you that they are not interested if a certain bond does not price at X, Y or Z, and if the issue does not come at that spread you will probably have no deal.
Christian Reusch: We also have a chicken and egg problem. On the one hand, investors are most likely cash rich and would probably like to do something, but on the other hand have little idea where the market is at the moment, as the secondary market does not necessarily reflect everything.
Also, a lot of issuers, at the moment are afraid of going out. They are not prepared to accept certain levels as they do not want to be seen as a fool for coming too cheaply and looking too desperate. But, I think at the moment this has nothing to do with being desperate. It is the right approach to be a little braver and to listen carefully to what investors would currently like to see and what maturities they would like to buy.
What you do as an issuer is the same as in normal markets, but probably with more sensitivity and with a little more generosity. This is something that we will be able to evaluate in a few months' time when we are able to look back and judge whether things were done properly or not.
Steffen Dahmer: We have been moving towards a new trend and HBOS is probably the first example of this, moving one step back to how we did it in the past. You looked at the secondary curve of your issuer, you added something for a new issue premium, you took into account what you were seeing in terms of secondary trading flows and what you were hearing in the market. Then you pitched in that way and you won it or you lost it.
Now, and HBOS is an example of this, you do some pre-sounding and you talk to your key investors because, as Christian said, you don't want to be seen as a fool by the market and not get what you want, and neither do you want to look too desperate.
I think that this is a trend that will guide us, or will be part of the syndicate model for at least a few months until things have calmed down and are normalised. I think it is a pretty smart idea to do that, because you have done your homework, you are doing your job. It has been working in the dollar market – the dollar covered bond or the dollar supra markets – for years perfectly and I think that is what we will see on the next transactions in covered bonds: that the selected banks have done pre-sounding, pre-marketing and soft book-building, and once it hits green it is already in good shape.
IFR: If we turn to some of the individual jurisdictions we have here, Thor, can tell us what you think is next for Norway and the positives and negatives of investing in Norwegian covered bonds?
Thor Tellefsen: We believe it is an advantage to us that we have a covered bond law in place in Norway. At least, this is what investors have told us, and we have been complimented by the rating agencies for the Norwegian covered bond law, so I think that is a good starting point.
But a key point in this kind of turbulent market today is that we think Norwegian covered bonds offer a very good and also new diversification opportunity for investors, because Norwegian covered bonds are one of the few ways investors can diversify into the Norwegian economy in Triple A format.
The Norwegian government is, in principle, not borrowing any money. It is a large investor and it issues some bonds in Norway just to create a yield curve. So this means that if an international investor wants Triple A euro-denominated paper with Norwegian risk, a DnB NOR covered bond offers a good opportunity.
Of course, then there is the question of why an investor would want to diversify into Norway. I think one of the key points is that the Norwegian economy is an extremely strong one. Norway is a very fortunate country: we have a lot of oil and gas, and the government handles the revenues from this in a very prudent way. We are not spending the money; we are investing it abroad and spending only a slight amount of it every year. This means that Norway has one of the strongest economies in the world.
Also, this means that the Norwegian government is sitting on large financial reserves, so if there should be a downturn in the economy, be it internationally or in Norway, it has the muscle to try and work against it. One of the specific things we also see in Norway is that unemployment is extremely low. We currently have an unemployment level at less than 2.5%, which again is important for Norwegian covered bonds because, since we have a lack of public lending, we have covered bonds based on residential mortgages, and a key element for residential mortgages is, of course, unemployment. There is also very little buy to let in Norway. If people are employed they pay their mortgages.
My last comment on Norway as an investment concerns sub-prime lending. At DnB NOR we have a totally different way of working because, when we grant a new mortgage, the first thing we do is actually determine if this a client we would like to work with, the payment history, et cetera, and we are continually calculating if the client will be able to pay back. We run a liquidity test and we stress test them for increasing interest rates. And when they have passed these two tests, we take a look at the proposed collateral.
We have very seldom seen any losses on well-secured mortgages in Norway within the last 15 years. So this is the story we are aiming to continue to tell to the market, and hopefully we will continue to gain investor confidence as a result of it.
Click here for Part three of the Roundtable.