Covered Bonds Roundtable 2009: Part II
IFR: What's the rating agencies' view on this? We have seen a shift from an almost exclusively Triple A market towards more Double A rated covered bonds?
Alessandro Settepani, Fitch: We implicitly said we viewed this as a credit product. That's our job. It is true that there has been a proliferation of jurisdictions issuing so the analysis of the legal framework and the credit analysis of the cover pool is very important. We want to facilitate a comparison among the different issuers within one country, and across the different countries. This is why we published our D-factor, to try to be as transparent as possible in how we arrive at our ratings, on the analysis we perform and the overcollateralisation needed to support our ratings.
Loughney: I came to this market quite late. The first time I heard of covered bonds was about three years ago and at that time I used to go to the conferences and argue with investors, telling them this is not a rates product, it's more credit oriented.
At Alliance Bernstein we always looked at the structures, jurisdictions and qualities of each individual covered bond. We always knew it was a credit product – probably the highest quality credit product. It's a senior debt product with protection; it's as simple as that. The problem in the past was that because investors perceived it as a rate product, it was priced as a rate product. I came to the market and thought: this is a nice product, I like it, but it's too expensive. I'm not talking about when it blew up 200 basis points and got embroiled in the crisis. It was already an expensive product prior to the crisis.
Now it looks attractive. What was once very difficult to buy became less so in September when we had this massive issuance. Since that time we have been able to increase our exposure to covered bonds to a level that we're comfortable with. We'd have loved it to have happened a few months earlier because spreads are now too tight again, certainly in the German and French names, to be so attractive. The liquidity has improved but they're too expensive.
De Bruin: Rating agencies must also be interested in the support these products receive. They are senior debt with financial institution support, bank support, backed by collateral. You have the government guarantee schemes, the issuance market opening up and the whole notion of "too big to fail". So there is an implicit systematic support. Did that change your views in terms of rating covered bonds?
Settepani: That affects mainly the rating of the bank itself, and as such is incorporated into our rating. In our covered bond methodology, yes, of course we take into consideration these factors, in terms of systemic support that can influence, say, the D Factor. By assigning a rating which is higher than the rating of the issuer we are basically assuming the issuer is in default very soon in the life of the programme. As long as the government support is incorporated in the rating of the issuer, we take it into account, but the rating of the covered bond will be even higher than the rating of the issuer and sometimes that the rating of the government itself.
Cuesta: That's where the rating agencies have run into the sand on this. The ECB has shown that this asset class is unlike any other. It is the only one that attracts this degree of government support, short of a government guarantee. There is no other asset class anywhere in the world – and never has been – with such support, maybe with the exception of the US agencies.
The asset class does enjoy a phenomenal – unprecedented – amount of official support. That's what the ECB has done. This has to be taken into account more fully.
Settepani: We do take that into account in the rating of covered bonds, especially when we have to assess what happens when the issuer has defaulted and there is an administrator that has to manage the cover pool. Let's say it has to sell a portion of the pool, because it needs to repay the bullet loan. At that point it is the systemic support that is important, because it needs to go to the market for a refinancing or to sell a portion of the portfolio and we do take into consideration the fact that other entities could step in to facilitate the process. So we incorporate the systemic force of the different jurisdictions into our D factor. But the starting point is still that the issuer is in fact in default, so government support didn't work.
Cuesta: The maturity is also crucial. Five year issues always perform much better than seven years or ten years.
But we have seen bonds performing from a level close to mid-swaps plus 120bp two or three months ago, to rally to levels that are much tighter. We saw a Spanish covered bond issued at plus 30 basis points, which was probably the end of the rally. That was probably the point at which the market realised it had to take a break to establish what the right price was now.
We have seen a widening in most of the names, although some names will be wider than others because of the credit quality or the volume or the maturity. But there is something else. While this widening was occurring, the other products of the same issuer, like Lower Tier II or even CDS were tightening. What investors have now is free money again. Investors have realised that the potential performance of three months ago is gone. Covered bonds are back to be a rates product again, and we will see performance of 10 or 15 basis points maximum moving around this area.
That is good because it is what the product traditionally was. But if you look at senior unsecured or Lower Tier II, some of them are offering the spread that covered bonds had three months ago. In the last three or four weeks covered bond investors have been trying to get a higher yield. I remember with the liability management exercises back in May or June, issuers were buying back subordinated bonds at 60-65%. Now they are close to 90% again. The market has really performed.
De Bruin: But wasn’t the stabilisation in spreads or the modest widening also a result of the market getting ahead of itself? Look back to September, when you suddenly saw huge oversubscriptions in new issuance. People in the market know F&C will show our real interest, but sometimes you have to inflate orders if you want to participate. The spreads were really pushed to the tight end of the range, and then the next issue comes even tighter.
Skeet: But that was your fault. If investors overinflate orders then it pushes the pricing down. That's what gives the issuers control.
Cuesta: We realised that was happening with all different transactions that were announced as the issue size with €1bn no grow, which was the typical announcement. Our experience was that if investors knew the previous book was oversubscribed four times, they are sometimes suggested to inflate their orders. We all knew that the last €1.5bn or €2bn of these transactions were inflated, and we tried to avoid that by not stating any amount, but it was a bullish market anyway.
De Bruin: I want to come back on the "that's the investors' fault" remark. Maybe it's the syndication team’s fault. Investors are just looking at a way to get a reasonable allotment.
Skeet: This is at the heart of one of the biggest problems. It all revolves around the syndicate. We don't have a syndicate manager here, but I did the job once, many years ago. The problem is trying to second guess what investors really want. That can be very difficult in an overheated market. You guys are good poker players, and sometimes you keep your real intentions up your sleeve or inside your jacket pocket. Sometimes the syndicate guys don't have that visibility.
De Bruin: We're transparent where we can be, actually.
Rad: In September everyone was really concerned about missing out on positions. When I saw the ING transaction, 10 basis points through where I thought the fair value for the bond would be and seeing it run very well, I thought that was the peak.
At the beginning of the year bids were so far way from par that even if a customer wanted to sell, they had concerns about making such a big loss. Now, the levels are closer or above the purchase price which makes people feel more comfortable about selling positions. That is getting the market back to a flow product again.
Loughney: We never inflate our orders whatsoever, but people do. In the corporate market it tends to be the hedge funds that run things, leaving us with the shrapnel. In the covered bond market there's so much demand anyway, even if they weren’t overinflating their orders, the demand is there creating significant liquidity.
Skeet: The size of the books and the number of investors seems to be significantly larger now than it was prior to the crisis. We lost 40% to 50% of investor capacity last year, including central banks and financial institutions that had no money left. This year I think we’ve had a something-like 20% move above the peak capacity of the past.
Guire: Is that because of the artificial support the market has had?
Skeet: I'm not sure it is. I'm much happier buying this and reporting to my superiors now than in the previous cycle when you had to take a lot more risk to make it profitable. Look where that got me.
Kvist: So who would these investors be? In the pre crisis market there seemed to be insufficient end investor demand for the massive supply of covered bonds being issued. The market was fundamentally out of balance before the crisis, contributing to some of the havoc we saw in the aftermath.
Skeet: Good point. I think about 40% of investor capacity was bank liquidity books prior to the crisis. Distribution charts consistently showed a big chunk of demand came from financial institutions and people providing liquidity to the market, not buying to hold. When the crisis hit that money evaporated, causing the plunge in the markets and illiquidity. Maybe we have a better balance of investors right now. It seems to me a lot of funds and buy and hold investors who previously invested elsewhere are now coming to this asset class.
De Bruin: The risk for us was always in the marking to market, we never doubted the product itself. When the government guaranteed market opened up it provided a very interesting alternative to sovereign bonds. Spreads were really wide and we saw more end investors showing interest in that field. When spreads started tightening for those assets in around July, interest shifted. Covered bonds are probably one of the safest products you can get, so naturally we have seen increased interest from customers.
Loughney: The market has broadened. We see more interest from insurance companies while banks are withdrawing. I think that's a good thing. Banks are very price insensitive; they wanted to get them on the books and were less sensitive to the premium. Real money investors are not necessarily as sophisticated but they're more discerning, they have more alternatives. That said, the market is still dominated by the French and German institutions, so it's only at the edges that you will see the benefits of this diversification.
IFR: Is the B2B part of the market conducted through companies such as ICAP?
Rad: The B2B business has moved largely to the inter-dealer brokers now which is an improvement on what we had before.
IFR: So the electronic bank to bank platforms which did exist are not such an important element of the business to business volume?
IFR: So have intermediaries such as brokers benefited from this development and helped to restore liquidity in the secondary market by taking up the reins of the electronic platforms which existed previously?
Guire: When the banks dominated the market everyone was led by what they saw on the screens. The first guy put an aggressive price up there and he could lead the market, the peripheral houses accepted what they saw on the screens as the price. If they wanted to steal the business from the bank making that price they'd offer something tighter.
We heard from plenty of market makers that they were no longer willing to make markets to everybody because they were being sniped by the banks – the smaller banks, the guys that only had six bonds to market-make. It's very easy for them – I sympathise with the guys who had to make prices on 360 bonds. Throughout 2008 and for the best part of Q1 2009, they were cannon fodder for the market and they were right to pull away.
I was quite critical of people trying to reinstate market making, not because it would benefit the voice brokers but because it would benefit the banks which, in the end, are our customers – the lifeblood of the marketplace. Where we go from here on secondaries I'm not sure. We need to see how the market can perform without artificial lungs.
IFR: Has transparency increased? In the sense that buyers are real buyers, sellers are real sellers, and there's no picture painting, which used to be in the case in other parts of the market?
Guire: People are still trying to influence the marketplace but not to the extent we saw before, because banks don't have the balance sheet to play those games anymore.
In addition, prices are available on plenty of different systems. They might be wide, indicative or firm but they're there, providing a guide as to where the price should be. Nine months ago it was like pinning a tail on a donkey, you really didn't know where you were going with it.
IFR: Are there any new initiatives in the secondary market to improve transparency or trading?
Guire: ICAP have developed a quasi black box scenario, based on the internet, where banks can submit their long / shorts and they'll get matched. We do not know about the positions, it's completely blind to us as brokers. Definitely it was going to be very relevant in 2008 and early 2009. We would have liked to have launched it in June but the ECB beat us to it. I think it will have a role to play once we see where the real secondary markets are.
IFR: We have Eurex as well, with its auction system. Has that been successful? Have we seen much trading on that?
Rad: The Eurex initiative came before the ECB announcement and was designed to provide liquidity. Banks did not want to have a continuous credit risk for the whole day in showing two way prices within a given bid/offer spread. They wanted something with less obligation.
On the back of the Eurex auction there are now also prices on the Eurex platform, at least for Germany, for a couple of hours. The sizes are no longer in €10m, it's now €2m–€5m. Traders are starting to provide liquidity to the B2B platform. Traders appear to have a preference for the Eurex platform.
IFR: So the ICAP system will allow banks to deal anonymously?
Guire: It will be anonymous, completely anonymous. There will be no price disclosure until there is another side.
IFR: So it's effectively closing a price electronically?
Guire: It's putting an idea up and if it's matched then it will trade. If it's non aggressive then it will not receive any information back. One of the things that we learnt from the market making days was there was too much information around for people to not trade with.
IFR: So it doesn't conflict with the intention or the market making of some of your larger customers to make prices independently? It doesn't provide a basis around which to quote a bid and offer, it provides a basis to unwind a particular position?
Guire: If the market moves towards banks wanting to make a bid and offer, not being forced but wanting to make a bid and offer – and I think it's crucial that we understand that some banks do want to make markets and some banks don’t – they can make markets into this system. Obviously they can't trade with themselves, but if there's somebody like minded on the other side of the transaction, or close enough that there will be a fair negotiation to a solid conclusion, then that interest will be flagged up and we can take over as voice brokers. It is not designed to replace voice broking in any way.
IFR: So essentially it does the initial stages of a trade electronically and finishes it off verbally.
Guire: I hope it gives people confidence to put prices in, knowing that they're not disrupting firstly their own market nor anybody else's market.
Loughney: Is this the same as interdealer broker screens in the gilt market?
Guire: I'm not sure how the WCLK plafrorm works.
Loughney: But it is the same kind of concept?
Guire: Ours is definitely not visible and I think WCLK is visible – or there is some visibility. We found in the dark days that the visibility was the thing killing the market. Nobody would make a market because they knew where the market was. They could see no reason to make a market when they knew where it was, so they didn't. That prevented people from being able to do their jobs properly.
Rad: The system is quite interesting. It is not applicable for German or French covered bonds but there are bonds where people are not willing to disclose the offer. If you don't want to show your offer you can put the level you would like to sell the bond at in, and then a range at which you might be interested, so it pops up on the broker screen so they are able to complete the trade verbally. That is very helpful because people do not see your position. As a voice broker, you have to show everyone the price. It's a quite interesting, challenging idea.
Guire: It's exactly as described. Traders can put in a bid or an offer on a difficult issue, but it really only works with the sticky ones, not the now so called liquid German market, though it might work on some parts of that market. A variance can be put in which you're prepared to tolerate and then if that's crossed with the other guy who's crossed on the variants, we'll get an alert on our desk and we'll contact both parties to try and bring it to a relatively swift conclusion.
IFR: It sounds in general as if liquidity, in terms of the secondary markets, has improved very considerably. Clearly that improvement is a function of the ECB role although, as Tim said, other sectors of the market improved, such as the SSA sector, so maybe it was part of a broader trend. But it takes us back to the first question. What are the prospects for the market when ECB support is removed, given it is already coming under a degree of pressure?
Skeet: It comes back to the question about the size of the core investor market. My gut feeling is, even taking away the ECB, it's probably as big as it used to be – if not bigger. But it is also a better quality market: this market has benefited from the crisis. This asset class came out fast, it beat the expectations of most of the analysts and it's performed pretty well. Yes, the ECB helped, but it's done extremely well. The market did what it says on the packet, really.
De Bruin: It has done extremely well but it's just coming back to levels which are basically in line – and maybe still not enough – to where this market should trade. I'm quite confident in its development and I'm not too worried about next year.
Guire: But next year you'd have the benefit of another €40bn of ECB money.
De Bruin: Yes.
Guire: In July, it stops.
Skeet: We've seen a tremendous recovery of markets. There is now a market for the unsecured bank issue, which there wasn't before. We have this tendency to look at our asset class as if it's the only thing in the world, but in fact there are markets within markets turning around it.
Guire: I suspect they have been a bigger beneficiary of the spread compression than some of the other markets.
Skeet: We can debate that and look at the curves. The covered bond has done spectacularly well and the senior unsecured has done pretty well, but it doesn't have the same depth or the same volume. It comes back to regulatory treatment. Talking to most issuers it's an incredibly efficient tool to use for funding.
Kvist: There's no doubt about that. I am cautiously optimistic, as far as the market is concerned, post the ECB purchasing programme. The end investor base has been expanded sufficiently, yet because I don't see a lot of supply going forward, I see relatively limited refinancing needs. I don't see a lot of mortgage or public sector lending going on that will require new funding.
I believe a lot of the supply in September was very opportunistic. When sentiment improves you will have investors going in willy nilly, but you will also have borrowers issuing regardless of whether it's really in their funding programme for the season if they have room in their cover pools.
Skeet: I agree with that. The syndicate managers have been talking about the lack of pipeline, yet every week we get deals, we just don't know about them until the last minute.
Click here for Part three of the Roundtable.