No safe haven
The covered bond market has not come out of the credit crisis unscathed, but up until September, it was at least still standing. However, the dislocation of the money markets and the dramatic rescue of two of the largest and most important covered bond issuers, coupled with rising redemptions, spell even tougher times ahead for the asset class. Rachelle Horn reports.
Raising new debt in the covered bond market over the past year has been far less simple than before the credit crisis. There was a time when vastly oversubscribed books were the norm, pricing often took place at the tight end of the proposed spread range and borrowers could access almost any maturity they needed.
But despite the bear market for credit, covered bond supply has continued – at a price. Access to the market has been limited to the short end of the curve, and issuers have had to accept a marked increase in their cost of funding.
However, the events of late September sent shock-waves through the sector as news that two of the largest and most important players in the covered bond market, Hypo Real Estate and Dexia, had to be rescued in a dramatic bail-out. With a combined €230bn of covered bonds outstanding, the rescue of the two institutions dealt a severe blow to the public sector covered bonds of France and Germany – the two countries that had previously shown the most stability and performance of all the covered bonds.
Spreads of DexMA and the Hypo Real Estate Group moved around 50bp–80bp wider in the days following the bail-out, according to covered bond traders, with Hypo Real Estate reportedly trading in excess of 200bp over mid-swaps. It is a far cry from the mid-swaps plus 9bp funding level the bank achieved for its €1bn April 2010 Hypotheken Pfandbrief in April.
Where jumbo new issue spreads of Pfandbriefe have for the most part stayed around the low single digits to mid-swaps, it will now be far more difficult and expensive for Pfandbrief issuers to raise liquid funds through the Pfandbrief product - an important cornerstone of the German capital markets.
While most analysts and market-makers appeared pessimistic on spread levels, some commented that any resultant widening was in part because these jurisdictions had a fair amount of "pain deficit" to catch up on anyway. But, the problem now is more with balance sheet than price. Some syndicate officials warned that there might not be any public jumbo deals in the coming weeks, or even for the remainder of this year, if the flight to quality continues. This flight to quality no longer includes public-sector covered bonds.
One possibility is that the huge widening of these jurisdictions could drag other covered bonds segments in its wake. Yet far from seeing recent events as the final nail in the coffin, covered bond professionals actually have reason to be upbeat.
Not all bad news
Despite the fact that marking-to-market has been costly as a result of the widening, Dan Shane, who heads Morgan Stanley's frequent issuer syndicate, believes there have been some positives to come out of the recent situation. "When banks have got into difficulties, covered bonds have been well looked after. Once people have had a chance to reflect, they will appreciate that different products pay different spreads for a reason," he said.
Adding to this sentiment, Ted Lord, global head of covered bonds at Barclays Capital, said that recent moves by governments in the US, the UK, the Republic of Ireland, Germany, France, and Luxembourg all highlight their serious support of the covered bond market. "The bank rescue actions have all had one common pattern – the one non-depository security that was supported in all of these situations is the covered bond," he said.
Where securitised products – and even senior, unsecured debt in the case of the US and WaMu – have been left out in the cold, covered bonds, so far, have received immense support. But with only €5.4bn of gross covered bonds issued in September, such support may not be enough to save the dried-up market while the great unwind continues.
"Before anything else, we need to re-establish the money markets and the CP market. Until we get the basic liquidity back, the rest is academic," said Tim Skeet, head of covered bonds at Merrill Lynch. "Since covered bonds have proven themselves to be significantly less risky, and government officials are supporting this sector, you will find that investors want to return to this market."
Either way, those that rely on covered bonds for relatively cheap funding and their ability to provide duration will ultimately face a new reality: at best, considerably higher funding costs; at worst, restricted or even no market access whatsoever for the rest of the year.
Adding to the woes has been a patent change in the average maturity of covered bond issuance this year. The higher cost of funding, increased risk aversion on the part of investors and an inverted curve has left issuance largely skewed towards the short end in the covered bond sector.
But in addition to the restricted access to long-term funding, rising redemptions in 2010 and 2011 could pose something of a conundrum for issuers if market conditions fail to improve significantly.
The amount of deals priced in a maturity of 10 years or more has come to a virtual standstill in comparison with previous years. Conversely, issuance at the short end has risen sharply.
According to Thomson Reuters data, the amount of short-dated debt priced so far this year in covered bonds with a maturity of two or three years has increased by 168%, from €10.6bn through 10 jumbos in the same period of 2007, to €28.5bn through 24 deals this year.
In stark contrast, the amount of issuance in the long end has decreased significantly. Just four jumbo-sized deals with a maturity of 10 years or more have been priced so far in 2008, which at a total volume of €5.4bn marks an 88% fall from the same period of 2007, when 30 jumbos amounting to €48.3bn were issued.
At the same time, in addition to the restricted access to long-term funding for borrowers, the covered bond market is facing a greater than average number of redemptions in 2010. According to analysts at RBS, these currently stand at €148.4bn, compared with €108.3bn in 2009 and €88bn in 2008 (see graph).
Considering the market is still attracting a wave of new borrowers and jurisdictions, funding in the covered bond market, particularly at the long end, could remain difficult, if investor demand does not increase at the same speed, cautioned Frank Will, strategist of the frequent borrower group at RBS.
Compounding the situation where redemptions are concerned is an overall reduction in jumbo supply volume, resulting from the weak state of the primary market. At the start of 2008, analysts optimistically predicted gross jumbo supply to be anywhere between €170bn and €190bn on average. Ten months on and volumes are dramatically short of this number with only €92bn issued so far, according to Thomson Reuters.
From an asset and liability matching point of view, covered bonds should generally be used for longer maturities and only temporarily for shorter maturities. The assets that underlie the covered bonds are typically long dated mortgage loans and public sector loans.
Given that for the time being the focus on the short to medium-term maturities is likely to remain, the potential problem of refinancing the increased redemptions could see borrowers forced down one of two roads: either they will accept the higher cost of long-term funding or they will change their strategies and reduce balance sheets.
Still, Leef Dierks, a covered bond strategist at Barclays Capital, said there is generally only modest pressure regarding the refinancing of maturing covered bonds. "Even if conditions stay as they are, issuing covered bonds will be possible: it will be feasible and it will make economic sense," he said.
According to Dierks, the distribution of term to maturity below three-years in the covered bond market increased from 40.4% at year-end 2007, to 42.2% currently. "That is a very sharp increase which is more or less attributed to the decline of the percentage of covered bonds with a term to maturity of three years or more" he explained. "Clearly there has also been a shift towards the up to four-year sector which was expected if we bear in mind that we have mostly seen two or three year covered bonds being issued."