Discovering new avenues
The supply of German covered bonds is still off its peak, but innovative structures give the sector some hope.
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How the mighty have fallen. The Pfandbrief market, Germany’s covered bond market, used to bestride the European capital markets. Only a decade ago, and driven by public-sector covered bonds called Oeffentlicher Pfandbriefe, issuance comfortably topped €1trn a year.
But then, in 2005, the EU got rid of the guarantees that protected the ratings and cheap borrowings of the German Landesbanken. No guarantees meant little impetus for public-sector lending. Virtually overnight this meant no need to refinance and no more Oeffentlicher Pfandbriefe.
Issuance fell off a cliff. According to Barclays, gross supply across Europe in the first quarter this year was €40.8bn. This is an improvement on the same period last year, which saw €37.5bn of issuance, but still a pale shadow of its former glory. The bank predicts €130bn for the entire year.
The figures appear even more gloomy in Germany, where the share of Pfandbriefe in the total bond market declined from 32.3% at the end of 2004 to 3% at the end of last year, according to Deutsche Bank.
“While the number of Pfandbrief issuers is increasing due to smaller banks entering the market and also total Pfandbrief issuance increased slightly in January and February compared with the same period in 2013, net Pfandbrief issuance will still be negative in 2014,” said Bernd Volk, head of European covered bond and agency research at Deutsche Bank in Frankfurt.
“Total Pfandbrief redemptions of around €76bn in 2014 compare with an estimated annual issuance volume of around €50bn – in other words net supply could be negative by more than €25bn,” he said.
It is the issue of redemptions that is key to the market. Until 2005, Oeffentlicher Pfandbriefe tended to have tenors of 10 years. These bonds will all have matured by next summer, ending the long period of negative net supply. But this long and slow contraction means investors have not been able to reinvest their redemptions.
As a result, demand for covered bonds remains higher than ever and is precisely what is driving the keen pricing.
“The tight levels we have seen in recent deals come from the negative net supply. If you have a limited scope of where you can invest your money, even a covered bond at mid-swaps plus 10bp can appear quite attractive,” said Torsten Elling, co-head of rates syndicate at Barclays.
In February, for example, 47 investors jumped on WL Bank’s new €500m three-year covered bond despite the mid-swaps minus 11bp price. That pricing level might appear extreme, but it is not wholly unique. Also in February, although the deal struggled slightly to get away, Commerzbank sold a €500m five-year flat to mid-swaps, predominantly to domestic investors.
The dynamic of the tightness of German paper even to agency debt is unlikely to go away soon.
Several covered bond bankers refer to two different deals in mid-April that express this clearly. Bayerische Landesbodenkreditanstalt (BayernLabo) sold a €500m 1.75% 2024 issue at mid-swaps plus 8bp. At the same time, the Council of Europe Development Bank, a financial institution that finances social projects, sold a similar-sized conventional bond with the same tenor. But CEDB’s €500m 1.75% 2024 came 4bp wider at mid-swaps plus 12bp.
“Competing supply from SSA issuers is having an impact on covered bond supply patterns,” said Christian Klocke, head of DCM bonds syndicate government bonds at Commerzbank.
Germany has had the covered bond space its own way for too long. The rest of Europe is starting to think about the covered bond format more seriously again – and it is offering more of a pick-up.
Close to home, in April Societe Generale sold a €750m 10-year covered bond issue at mid-swaps plus 26bp – a distinct pick-up of at least 14bp over similar German paper.
The tightness of German issuance is having an impact on tenors.
“There is a demand for longer tenors, especially from real-money accounts, even if issuers really do not want to fund that long,” said one German covered bond banker.
A couple of 10-year deals have already been seen in Germany this year. At the beginning of April, as well as the BayernLB deal mentioned above, UniCredit HVB sold a €500m 10-year covered bond issue. UniCredit’s paper came at mid-swaps plus 12bp with a coupon of 1.935%.
What is driving this issuance in general is the need for higher coupons, preferably above 2%. Many pension funds demand that figure as a minimum. At the moment this is being delivered outside Germany.
The SG deal mentioned above had a coupon of 2%, while at the end of April, Compagnie de Financement Foncier, one of France’s national mortgage banks, sold a €1bn 10-year at mid-swaps plus 32bp with the same coupon.
“The market will remain highly receptive for further long-dated deals as low yields persist,” said Ralf Grossmann, head of covered bonds at SG.
But the covered bond format has begun to evolve. The last couple of years have seen several innovations with the covered bond structure – not to say that these have been entirely welcomed with open arms.
“This is a challenge. Every potential portfolio in the market is different. Can these products really become an asset class, with all economies of scale, or will they remain tailor-made niche products?” asked Oliver Dreher, a partner at CMS Frankfurt and a member of the external lawyers’ workshop at the Association of German Mortgage Banks.
At the end of February last year Commerzbank sold a structured covered bond issue secured by a portfolio of SME loans.
“Within the current low interest rate environment, the product represents a genuine alternative for investors seeking attractive returns and a safe investment. This is particularly evident from the high demand from classic Pfandbrief investors for the issue. We are opening up a market for these instruments with this transaction,” said Roman Schmidt, global head of corporate finance at Commerzbank.
The 1.5% €500m five-year covered bond issue was sold through Barclays, Commerzbank, Credit Agricole CIB and UniCredit at mid-swaps plus 47bp. The deal, still controversial, hit a book of €1bn thanks to the generous pricing, before printing halfway between comparable covered bonds and senior unsecured.
As a means of supporting lending to small and medium-sized enterprises, the backbone of the German economy, the deal cannot be faulted, but covered bond bankers remain cautious. More to the point, another similar deal is unlikely this year.
“The SME market is small, and the cost of set-up is high. The demand is there from the investors, but it is simply not viable from a bank point of view,” said one German banker.
A different approach was seen in mid-February this year when Norddeutsche Landesbank came to market with an aircraft Pfandbrief transaction. This was only the second such deal to hit the market. The first had come, again via Nord/LB, in 2012.
Then, the €500m five-year deal had been priced at 55bp over mid-swaps. With that paper trading in the secondary market in February at mid-swaps plus 9bp (at the time of writing it is a touch wider at 13bp), a new deal at mid-swaps plus 22bp seemed more than fair. But although the deal printed, it was not regarded as a success.
At first glance it is curious why this should be the case. The paper provides a good diversification for the investor portfolio; the assets in the pool are good quality; and there is a good secondary market for aircraft. The challenge, however, was the A2 rating from Moody’s (it has since been upgraded to A1).
“The rating uplift of only one notch above the senior rating of the issuer pushed back some investors. Since then, there has already been an upgrade by one notch and there is more uplift to come as soon as Moody’s is able to assess the high quality of the pool properly,” said SG’s Grossmann.
Yet it is too soon to write off the aircraft Pfandbrief structure. Despite what can fairly be described as teething difficulties, it would be easy for another deal to come to market now that there are two reference points on the curve.
More to the point, it is an open secret that DVB Bank, the Frankfurt-based specialist in commercial transportation finance, established a €800m cover pool for aircraft earlier this year. Whether it will print or not is another matter, but technically it could and it has clearly been thinking about it.
Many have tried to write the obituary of the German covered bond. It is true that issuance for the past few years has been thin, but new structures show that even in the conservative world of German finance, evolution is possible.