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Tuesday, 12 December 2017

Equilibrium

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The covered bond market experienced a record first quarter this year. Investors clambered over each other to buy up as much of the product as possible, leaving senior unsecured debt out in the cold. But with a limited amount of collateral available, bankers believe a balance between the two markets is likely to develop. Aimee Donnellan reports.

To view the digital version of this report, please click here.

Since the start of 2011 the covered bond market has seen a flood of €130bn of issuance. The deluge has left some bankers wondering whether we are currently witnessing the replacement of senior unsecured funding by an improved, reinvigorated covered bonds market.

Covered bonds have been shown in a very positive light this year. It helped that they are excluded from the contentious European Commission’s consultation paper that could result in a radical shake-up in the rights of senior unsecured bondholders. The product also boasts an unparalleled record of never having suffered a single default since the market began in 1769. It also offers dual recourse to investors.

“There is definitely a bias in the market towards covered bonds,” said Christoph Alenfeld, head of covered bond syndicate at DZ Bank. “I think issuers are favouring covered bonds over senior unsecured in this market but it will be interesting to see how much supply covered bonds can really provide.”

Favourable regulatory treatment of covered bonds has lured new investors to the product, often at the expense of senior unsecured bonds.  “The sentiment surrounding covered bonds is very favourable,” said Marc Stacey, covered bond specialist at Bluebay. “Whether it’s due to the talk around bail-ins for senior debt or the fact that they are likely to get comparatively favourable treatment under Basel III, investors are comfortable with the product in the current market.”

New buyers

“We are seeing a sizeable component of UK asset managers and even hedge funds , that have not previously considered covered bonds , now buying the product,” added Jez Walsh, global head of covered bond syndicate at RBS.

In Ireland, which already has legislation that protects investors in the event of default, fresh concerns over the ailing banking system have driven rates investors to sell their covered bonds to European and US hedge funds.

Once trading began in January, hedge funds started showing interest in covered bonds,” said Torsten Strohrmann, a senior portfolio manager at DWS. “Usually, you don’t get investors looking for discredited debt but hedge funds were ready and waiting.”

Last year, syndicate officials at banks managing covered bond issuance observed these investors were buying senior debt to obtain high yields. But with the constant threat of senior debt haircuts and the possibility of being bailed in, covered bonds seemed like a much safer option at very attractive spreads.

“If the market is volatile, investors will naturally gravitate towards the most defensive instruments,” said Mark Geller, head of financial institutions syndicate at Barclays Capital. “Covered bonds will remain in strong demand but high quality senior unsecured debt from national champion banks will always see a reserve of appetite.”

Covered bonds investors are given legal rights to both the assets within their security’s asset pool and the more normal recourse to the issuer. For this reason, they have been excluded from the clamour in Ireland for senior bondholders to be bailed in. “Ireland has a covered bond legislative framework that explicitly excludes covered bonds from the insolvency of the sponsoring credit institution,” explained Ralf Grossmann head of covered bond origination at SG CIB. “If covered bonds were to be included in bail-ins, then you might as well declare Ireland’s covered bond legislation null and void.”

At the beginning of this year, Irish covered bonds – AIB’s €1bn 3.75% April 2013 and €1.5bn 4.875% June 2017 issues and Bank of Ireland’s  €2bn 4% July 2013s, €1.5bn September 2014s and €2bn June 2015s – were seen to be trading at 1,000bp over mid-swaps. Since then they have tightened to the 600bp level.

“Certain courageous investors bought at 1,000bp and sold at 600bp, and while some people are waiting for further tightening, this kind of buying is directing the Irish market,” said Grossmann. Hedge funds remain active investors in Irish covered bonds, and have also started to turn their attention to other high-yielding issues from Portugal and Spain’s cedulas market.

Indeed in peripheral Europe, most notably Spain and Italy, covered bonds have been one of the only routes banks have to the public market.Since the beginning of January, Spain’s national champions Santander and BBVA have issued billions in covered bonds, though they have had to pay hefty spreads to lure in investors. “Covered bonds have become a funding tool which banks in non core European countries can utilise in difficult market conditions because of the added protection the product offers investors,” said Stacey. “This was particularly evident at the start of the year where many issuers took advantage of the open window and front loaded their funding programs.”

Usurped?

Looking at the current state of the market has led many to conclude that covered bonds are likely to become the new senior debt class, according to Georg Grodzki, head of credit research at Legal & General Investment Management.

Unsecured investors were spooked by the European Commission’s discussion paper on bank resolution, which proposed that, from 2013, bonds could be subject to loss absorption to help keep banks afloat.

Before the credit crunch the majority of senior bank bonds were issued in floating rate form - bought mostly by money market funds, SIVs and banks’ treasury operations, said Grodzki. Real money traditional institutional investors mostly bought bank paper only when it was fixed rate lower tier 2 and Tier 1.

“Under the Basel III framework [tier one] is most unlikely to be suitable for traditional investment grade institutional investors, which instead may take up future covered bond issuance, which will be predominantly issued in fixed-rate format,” said Grodzki. “Real money accounts have already been wooed by the higher yields longer-dated covered bonds can offer. But it’s not just the coupon hunters that are changing tack; according to various syndicate managers, there are a host of senior unsecured investors now looking at covered bonds for the first time.”

Covered bond syndicate officials do not believe covered bonds will supplant senior unsecured this year. Capacity constraints will restrict the progress of this trend: senior unsecured bonds are the workhorse of European banks’ wholesale funding, accounting for US$458bn of issuance in 2010, against just US$185.9bn for covered bonds.

And it is not just investors that have capacity constraints. Covered collateral pools require considerable overcollateralisation (OC) to secure high ratings for the bonds issued, which ties up assets. Before the crisis the average OC was 5% of the pool. Now it can be as much as 25% for mortgage-backed which make up 80% of covered bond issues.

Because borrowers have to pledge assets to a pool there is a limit as to how much covered bonds an institution can sell before encumbering its balance sheet and structurally subordinating unsecured creditors – including depositors.

Once the uncertainty over the regulatory future of senior debt is removed and investors can accurately gauge what their risk is, the market will find a price. “The yields are better for senior unsecured than for covered bonds and the truth is that the good banks are becoming much safer in response to Basel III,” said Mauricio Noe, head of covered bond origination at Deutsche Bank.

The spread difference between covered and senior unsecured bonds used to be in the single digits before the crisis. Now, depending on institution and country, it can be considerable larger. Spain’s national champions’ unsecured bonds are currently between 50 and 70bp more expensive than covered.

Whether this differential adequately compensates borrowers for tying up mortgage assets depends on many factors. But Noe believes that many banks would issue covered bonds even if the spreads were flat to unsecured, given the benefits of investor diversification.

The senior market was buoyant leading up to the Easter holiday period, with another strong week following it, but investors are still concerned about the amount of covered bond issuance according to the latest quarterly survey of fixed income investors by the rating agency Fitch. Some 87% of respondents said they were concerned about potential structural subordination caused by banks’ recourse to secured funding, with 16% of that sample describing themselves as very concerned by the possibility of increased loss given default.

Fitch is sanguine about the outlook for unsecured investors in view of regulatory limits and the availability of qualifying assets. As risk aversion falls, the economics of secured versus unsecured funding will shift in favour of the latter, it said.

“Fitch would expect to see an equilibrium being reached, which, for the majority of sound banks, is unlikely to be a material threat to the status of unsecured creditors,” said Gerry Rawcliffe, managing director in Fitch’s financial institutions group.

“I don’t think we will see covered bonds take over from senior debt,” concluded Torsten Elling, managing director of rates syndicate at Barclays Capital. “Although we are seeing more supply coming from covered bonds, the market needs both products.”

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