IFR Pfandbriefe Roundtable 2016: Part 1

IFR: Welcome to IFR’s 2016 Pfandbrief Roundtable. As ever, there a number of interlocking themes that I wanted to pick up on in our conversation: the current market environment (both primary and secondary) in the context of both the redemption calendar and the impact of the ECB’s ongoing Covered Bond Purchase Programme, and against a backdrop of volatility in global credit markets; and how 2016 might pan out in terms of funding requirements.

I also wanted to spend some time on the harmonisation process and the European Commission’s covered bond consultation paper. What are the prospects for Green and SRI covered bonds? But let’s kick off with the current market. This year has been busy so far, with issuance from borrowers out of Canada, UK, France, Austria, Spain and of course Germany. Thomas, could you give us a wrap?

Thomas Cohrs, NordLB: The main theme we’ve observed since the beginning of the year is that covered bonds are still very much in demand when markets look jittery – as long as they’re not too jittery. As you mentioned, we have seen a number of issues from various jurisdictions. Those I would mention most notably in that context would be non-European borrowers or borrowers from outside of the eurozone that are not eligible for the ECB Covered Bond Purchase Programme. They seem to have had the best run with investors.

There have been exceptions to this, though. In terms of Norwegian issues, for example, you had the country’s major issuer [DNB Boligkreditt] having no problems printing a €1.5bn transaction whereas a smaller issuer with similar quality from the same country [SR-Boligkreditt] didn’t find it quite as easy to fill even a €500m book at a higher spread because of its lesser recognition.

That is mirrored with the Canadians and will likely be the case with issuers from regions far beyond Europe – from Asia, Australia and New Zealand. We haven’t yet seen those coming to the market this year but they will.

Within the eurozone, Pfandbriefe have the benefit of being the tightest product, and we have seen more issuance intended and waiting to come to the market. The deals we have seen so far have tended to be from the safest sources. For example, we’ve had two Landesbanken issuing [BayernLB and LBBW] and we are waiting for more to come.

The usual suspects for potential spread widening i.e. peripheral issuers or even French issuers have seen their fair share of issuance, with various degrees of success. We saw a very successful deal coming in the belly of the curve that amassed an order book not too far away from €2bn but they had to pay a new-issue premium of around 8bp, shifting the whole French curve up.

And then we had an announcement from another French issuer at the longer end of curve that has not come to market yet, but that announcement alone shifted the curve up. The upshot being that whenever we see new issues coming, the requirements for new-issue premia tend to be higher than originally expected and they have effects on the secondary curve that people fully expect but still seem surprised when they see it.

This is especially evidenced in the surprise we get from investors when they try to switch out of existing bonds that appear to have tightened in order to take profits and position themselves for new deals, and find that the mere action of trying to switch out changes the price and they barely end up with a profit at all.

I expect that phenomenon to continue throughout the year. Why is that? The ECB is playing the role of the puppet-master here in many respects but it’s not only that: there have been shifts in investor interest as well. But in general I still think it is going to be a better year for covered bonds in terms of primary issuance. I continue to be very negative in terms of secondary liquidity but on the other hand that ensures a further role for intermediaries like ourselves, which is a good thing. I think the covered bond product is going strong, as we expect it to.

IFR: When we have jittery markets, does the syndicate function need to be more forensic in its approach to the market in terms of which point in the curve you hit the market, the pricing indications you put out and how you manage the messaging on the way towards print?

Thomas Cohrs, NordLB: That’s a general hallmark of the syndicate function: to find the right timing, to find the right execution strategy, to find the right pricing to satisfy both investor needs and issuer needs. That’s textbook rhetoric but it is the way I perceive my everyday job.

With the ongoing jitters in the market, execution windows become somewhat shorter than they used to be. Changes of sentiment can occur very quickly; after a run of successful deals you can be the unlucky issuer who just hits the market with that last deal that is not successful.

That risk has increased somewhat, which has led to pretty strong focus from issuers to question the banks involved towards execution risk i.e. what the recommended course of action is going to be if the deal fails to fulfil expectations, whether pricing is as projected by initial indications or in terms of development of the order book.

IFR: Let me bring in our borrowers at this point. Jörg: having come into this year and seen how the market was, what were your thoughts in terms of how you felt you needed to approach the market, in terms of new-issue premium, in terms of soft-sounding your investor base? Did you perceive you needed to do anything differently?

Jörg Huber, LBBW: I would compare it to our behaviour a year ago. In the middle of last year, when market windows were coming and going quite quickly, we changed our attitude and approach so that we are now prepared to issue from one day to the next. That means investor work is not done for covered bonds insofar as we do deal-related roadshows; we try to keep investors continuously updated and use market windows.

That was what we did in the second half of last year and it’s what we did at the beginning of this year. This year, we intended to do our transactions in the longer-term sector, and as we saw that levels were such that we could issue even four-year transactions with a positive yield, we switched to four years.

You can’t really plan and say: “OK in the next few months I will do a transaction with this kind of tenor”. You don’t have that kind of flexibility anymore because you need to react to market conditions. When it comes to new-issue premiums, we have very low yield levels overall and margins are at fantastic levels; (of course they have widened a bit but they are still quite fantastic). The new-issue premium is a function of illiquidity in the secondary market.

If you request prices and you want to trade something, bid-offer spreads are huge so a new-issue premium is just a cushion effect that investors need to have because nobody knows where the secondary market is. And of course there is an added cushion when there is a bit more volatility in the market, but overall I don’t think new-issue premiums will decrease as long as we lack substantial secondary market activity.

IFR: So does that approach of being ready to issue day-to-day mean you necessarily focus more on your domestic investor base ahead of international interest?

Jörg Huber, LBBW: Not at all because at these levels, our domestic investor base is not really interested in covered bonds. The only domestic investors who buy covered bonds at these levels are banks because they need them for their Liquidity Coverage Ratio. And central banks, of course.

But traditional investors who need to play the curve or invest in certain kind of maturity buckets are looking for assets which yield more and which offer some kind of pick-up. I don’t think they have left the covered bond market forever, but as long as we see this very low interest-rate environment and spreads are compressed by the ECB Covered Bond Purchase Programme. I don’t see them coming back.

Götz Michl, Deutsche Pfandbriefbank: For us, it’s the contrary: the main difference is the international investor base. Looking back a year or two, we had a nice portion of non-German investors but what we are now seeing is that the portion of foreign investors in our transactions has declined.

We now have a higher portion of German investors and there’s some very positive granularity in our books; a large number of investors (small German banks and asset managers) with small tickets. What is really missing is the larger foreign bid. That is an interesting development, given that over the last few years we had managed to get more attention from non-German investors, partially due to what we did with the VDP on international roadshows. Today that has reversed. We only see a few larger tickets from non-German asset managers or non-German banks for their liquidity portfolios.

As Jörg said, spreads are still very low and we can achieve good results. We’ve had the Purchase Programme for over a year and the outcome is more or less what we expected. We discussed this a year ago and said it would drive prices down. We had the tightest prices last May/June where spreads were -15bp, -20bp. They’ve come back a little, with the ECB still being largest investor. On the positive side, we have good granularity in our books from the German investor base, which is fine.

IFR: Jörg, you mentioned that execution windows are shorter than they used to be and are probably going to be quite tricky this year. Does this mean that when you come to market you want to raise as much as you can? For example, we saw a French issuer raise €1.5bn today on a €1.8bn book which suggests they are taking out a lot of the available liquidity. Will that be your strategy: to do as much as you can, take the money and run?

Jörg Huber, LBBW: Definitely not. We certainly do benchmark transactions of €500m or more but as we also have limitations in the maturity buckets, we simply cannot go and say: “OK I’ll do a benchmark and take whatever demand emerges”.

Our maximum is normally somewhere around the billion mark but that is quite unusual. Even if we had more room in a given maturity bucket, from the perspective of cover pool and future cashflow management, it’s much more intelligent to take a maximum of €750m but then do something in that maturity bucket again half a year later. It’s quite difficult to manage the whole pool if you fill up as much as you can in one go.

Sabrina Miehs, Helaba: That might be different for a public sector Pfandbrief versus a mortgage issue because of the different amortisation profiles on the assets side.

Götz Michl, Deutsche Pfandbriefbank: We have a figure of around €750m that we don’t want to exceed. Larger transactions are unfavourable for the over-collateralisation requirement and our ALM profile. What we would have done in the past would have been a no-grow €500m deal followed by a €250m tap a couple of months later. That has changed a bit because our experience is that taps do not work that well any more – maybe because of the ECB – so if we want to produce €750m per benchmark, we now do it all at the beginning and not in a two-step process.

Thomas Cohrs, NordLB: I would add that covered bonds in general and Pfandbriefe in particular have shown a much stronger degree of resilience than the senior market. I would venture that in the senior market you might see a tendency towards taking what you can get because it might not get better any time soon all other things being equal. There will be fewer market execution windows for senior unsecured than for Pfandbriefe.

In the Pfandbrief market, due to the structural constraints that both Götz and Jörg have alluded to, I don’t see that. For our own issuance, we always aim for €500m to €1bn but the limitations are on the cover pool and of course the LM side; that puts restrictions on us.

There were days not too long ago when salespeople would come to us and say: “look, you’ve got to do a billion otherwise the big boys are not going to buy; a lot of investors want to see a billion because that is their size; that’s what they want to do and they want a big participation”.

Those days seem to be gone for the moment. Everybody in the market seems to have grown accustomed to the €500m general benchmark ticket and that is the accepted size. So in that respect I don’t see a problem.

IFR: Let me move to you, Sabrina. Bearing in mind all of the market factors, including broad volatility, CBPP3 and other factors (redemption flows and where Bund futures had been trading in the early part of 2015), and the onset of negative yields, can you put Pfandbriefe in the context of the overall covered bond market from a valuation perspective?

Sabrina Miehs, Helaba: Relative value hasn’t been disrupted. We still have a certain ranking between the countries but everything has narrowed so you have disruption there in that the difference between the spread curves has been eroded.

The problem for the covered bond market is, as you said, negative yields out to four years. That has consequences for private placements for insurance companies, which are reducing as a result. So we’re seeing a lot of benchmark issuance because of it but also because of regulation and LCR-driven activity which has changed the market and which we will continue to see this year.

IFR: Jens, can you comment on the EU harmonisation proposal? It’s only reasonable for the EC to look at the root causes of market fragmentation and try to understand market inefficiencies and their motivations, particularly around the repatriation of investor flows to their home markets post-crisis. Am I right in thinking that when it comes to the 29th regime, while you thought this wasn’t necessarily a good idea you weren’t totally against it?

Jens Tolckmitt, VDP: On the EC consultation paper, we are against the 29th regime approach because we think there is a danger of such a regime being a Trojan horse for full harmonisation in the long run. We want to avoid that and don’t want to give people the possibility to design regulation in the future that builds on that so that we end up with a uniform European covered bond.

That is the biggest danger of the 29th regime. As long as a 29th regime stands alongside the other 28 regimes, and they are all treated equally, we don’t think it is harmful but neither do we think it is necessary. It increases complexity rather than reduces complexity, which is what Brussels wants to do.

Maybe a uniform covered bond is interesting for countries whose domestic covered bond markets are not that successful or not as stable as the Pfandbrief market. Maybe that outcome is an option for issuers. But once regulators have created such a regime, it typically comes with strong inducements to incentivise its use.

And if you incentivise users of this regime, the consequences in the long run are that you end up with one regime and all the national regimes – whether they’re successful or not – will suffer, or in extreme scenarios, vanish. We want to avoid that.

What we favour – and we told the EBA more than a year ago – is harmonisation at a high-quality level. And a stricter definition of what covered bonds are on a European level in the interests of the overall product. I do think that this is in the interest of the whole industry – not only in Germany but across Europe – in order to make sure that the significant but nonetheless justified privileges we have received in the past few years, given all the regulation we’ve seen for banks in general, remain justifiable for regulators in the long run too.

If you get this kind of privileged treatment, the logical consequence will always be to focus on your product and you have to make sure that everybody who is designing regulation feels comfortable with it. You can do that by tightening the definitions around certain areas of your product.

The VDP defined those areas early on around asset classes, transparency, special supervision and the insolvency regime with regard to the position of investors in case of issuer insolvency. We would opt for either recommendations or some binding regulation in this regard, maybe with an add-on in terms of recommendations by the Commission around how to fill that at a national level – with the possibility to go beyond what the Commission prescribes.

The consequence of this is that national regimes would remain intact. You would still have the possibility to work on your national regimes and seek better solutions. This is something you wouldn’t be able to do if you had only one product. There would be competition between different systems and we think this is the best way forward.

Also, based on many discussions we have had, it is our strong impression that the vast majority of the investor base prefers to chose from a variety of products and doesn’t want to be forced into a single product.

With regard to whether regulation can change fragmentation into national markets, I doubt that regulators will be able to change investors’ perceptions of what they want to buy and how they want to buy. I don’t think harmonised European regulation will be able to change that. Unless you get rid of all 28 regimes.

IFR: Frank, the ECBC response to the European Commission consultation was similar in many respects to the VDP’s. Could you summarise where the ECBC comes out on this? Could I also ask you more generally whether you think that the Commission should be spending its time on this broad notion of pan-Europeanisation?

They are doing it in private placements, for example, and they are pushing ahead with the much bigger Capital Markets Union agenda. Their work around covered bonds is part of the same track. Could I ask you to talk about the issue from a first-principles perspective and then summarise the ECBC response?

Frank Will, ECBC: When I first read the consultation paper, I was really surprised about its depth and breadth. I was also a bit worried, given that the covered bond market had weathered the global financial crisis so well and my concern was that the EC was trying to play around with a well-functioning market in order to achieve their over-arching goal of EU harmonisation. There is a big risk that they are distorting it and hurting the covered bond product.

That is why the ECBC was quite keen to get a meeting with the Commission. We had a meeting with them in December, along with different stakeholders from across Europe, and we asked them: “what is the driver behind your consultation paper given that the market performed so well”?

The feedback we got was actually quite positive. On one hand, they recognised and acknowledged the strengths of the covered bond product, how well it performed during the crisis and how important it is for the mortgage and the public-sector markets.

On the other hand, they also raised the issue of the different performance they had seen during the crisis between Italian/Spanish covered bonds and German/French covered bonds. What they want to find out is how much of the underperformance of Spanish and Italian covered bonds was driven by the sovereign and how much could be attributed to the covered bond framework.

To put it differently, if Spanish issuers had had the German Pfandbrief Act, would the underperformance have been as pronounced? That is one of the important aspects of the consultation paper.

The other issue is this whole discussion about investor behaviour and the fact that during the crisis we saw a strong focus from the domestic investor bid on their own products while non-domestic buyers shied away from putting their money into these bonds.

Early-stage feedback suggests the EC is not going down the route of having a full-fledged regulation in regards to the harmonisation of covered bonds; it seems more likely that they are planning some kind of directive focused on principles-based harmonisation.

As Jens mentioned, there are a few high-level areas they could target: transparency, asset securitisation and public supervision. We see across Europe that supervisors have adopted different approaches so there is still room for a more standardised approach.

All these factors would be possible without hurting the product and would actually support the product, in my view. But what is really crucial – and a point we at the ECBC have highlighted – is we don’t want a one-size-fits-all approach for all markets. It is so important to have the flexibility and to allow innovation and different models.

I have been a covered bond analyst for many years and in the past I was always a big fan of issuers that were well-diversified across Europe and were active in different asset classes. Then along came the eurozone sovereign crisis and I thought: “OK, I now prefer to have a pool of domestic/residential mortgages”.

The point is: we need to have this flexibility in the product and we need to have choices. There are lots of different investors: some prefer to have covered bonds backed by one asset class out of one country; others see the benefit of having a more diversified pool, both in terms of residential/commercial real estate or in terms of countries.

Jens Tolckmitt, VDP: One thing I took away from the whole consultation is that on a broad level, the views Frank and I have just outlined represent the views of the whole industry, no matter where they come from.

I don’t know anyone who is arguing in the direction of one European covered bond regime. Or even the possible danger that I outlined by a 29th regime that pushes long-term development towards one covered bond model in Europe. That is quite interesting. It is very unusual and quite remarkable in European debates that there is a joint feeling about the right direction.

Frank Will, ECBC: We had around 750 stakeholders including the VDP and other major players contribute to the ECBC’s response. We hope the European Commission takes that on board. We got the first indications following the EC’s own covered bond conference on February 1 in Brussels.