Pfandbriefe/Covered Bonds 2007: Irresistible diversifier
Liquidity, attractive spreads on a risk-adjusted basis and diversification make covered bonds one of the hot favourites among investors. While a US dollar-denominated issue from a US borrower would certainly add more depth and breadth to the market, with more countries poised to enter the arena, investors do not have to worry too much about concentration risk in their portfolios. Malini Menon reports.
Any asset that offers diversification is good from an investor’s point of view, and covered bonds are no exception. New names, new markets, improved legislation and Basel II are fast making the asset class an irresistible diversifier, and with no shortage of financing demand coming out of the market, liquidity looks here to stay.
While investors’ views on covered bonds as a flow or a credit product differ, all agree that investing in the Triple A rated asset class offers good diversification for a government bond portfolio. “We do not see covered bonds as a flow product as many do, but as a credit product,” says Dominique Linder, vice president and portfolio manager of ABS and covered bonds at PIMCO.
“I think there is more event risk than people price in these days. When the issuer/originating bank defaults, the recovery value might be a 100%: however, there is a mark to market risk. We, as a total return investor, have to take this into account and have to avoid downgrades and losses in market value. The main risks come from aggressive underwriting/lending in non-home markets and from interest-rate risks taken by the banks. We monitor this on an ongoing basis,” he explains.
Investors who consider covered bonds as a flow product cite the high quality and ratings as the main reasons. This also serves to limit the usefulness of extensive credit analysis.
“Covered bonds are a flow product with a little bit of event risk attached that materialises once a year (for example, AHBR, BAWAG),” says Mahmoud El-Shaer, head of European credit at State Street Global Advisors (SSgA). “In the current environment, it is very difficult to add any value to the credit analysis of covered bonds because investors do not differentiate between the spreads or between the different credit risks. But, if the cycle turns and becomes more volatile, this will change.”
New covered bond markets in Scandinavia and the US are expected to boost the demand for domestic and non-domestic covered bonds. “Opening up the US market should bring more diversity in spread levels, especially since the real estate market there seems to be at a different stage of the cycle than over here [in Europe]. Though I am not bullish on that paper, I think the market will benefit out of increased issuance from the US,” says El-Shaer.
The opening up of the US market is a sign that the covered bond market is becoming a world-wide asset class, says Rob Dekker, portfolio manager, euro government bonds, at F&C Asset Management.
But, it is not without hurdles. Some US investors say they cannot invest in covered bonds because it is a credit product and that credit portfolio managers will not buy into it because they do not get enough yield pick-up. They would rather buy RMBS, where more spread is on offer for the mortgage collateral risk. The situation will naturally become clearer when the market sees the first US dollar covered bond issue from a US borrower.
According to one strategist, investors eventually expect to get 5bp–10bp pick up versus the GSEs such as Fannie Mae from covered bonds. It is estimated to be around 15bp now, the question being when it will begin to narrow, which will be a function of supply as well as liquidity.
No sub-prime spillover
European investors find it difficult to see any spillover from the recent sub-prime lending debacle that gripped the US market. According to them, banking system in the US is in good shape and at a good point in the cycle where it can absorb such losses. “We were waiting for some flows and for spreads to widen, but we have not seen any significant spread movements,” says PIMCO’s Linder.
“When we compare this to the last real crash in the real estate market which happened in Europe - in the UK in the early 90s - it was because of the currency system, as the Bank of England raised interest rates too much. But now, with the ECB much more focused on the real estate market, rates would be very unlikely to rise to such high levels,” he adds.
The weakest part in the Spanish market is the failure to implement the full cover pool system, due to which the solvency procedure has not been fully accepted by the market. Hence, there is a slight risk premium in the market price for Spanish names. “We look at how exclusive our claim is on the underlying asset,” says Linder.
In terms of financial strength, he thinks Spanish banks across the board are in better health than the German banks. “If you look at the underlying market, Germany had difficulty for many years - at least five to 10 years. The Spanish underlying market has been booming during these times and we do not anticipate any depreciation in the Spanish market. I do not think there is a bubble here that will burst.”
“We invest in all countries, as spread differentials between countries are not very varied. Spanish issuers offer only marginal risk premia, but covered bonds out of Eastern Europe could offer more risk premia,” says SSgA’s El-Shaer.
“I am bullish on the asset class and hence am overweight on my portfolio of covered bonds and swap-related products. They offer very attractive spreads on a risk-adjusted basis. Even though the spreads are normally much lower than corporates, covered bonds have less credit risk. In the whole investment-grade space, covered bonds offer the best risk-adjusted return expectations,” he adds.
Value in the middle
Given the demographic and regulatory changes in Europe, issuers expect a strong demand for longer maturities. As of now, however, investors see most value in the middle part of the curve (five to 10 years). “Covered bond spreads have tightened in dramatically at the very short end of the curve and at the longer end –10-years and above – they are still very dependent on the swap spreads. So we feel we are well protected in the middle, which also offers some attractive roll-downs,” explains Linder.
F&C’s Dekker agrees. “From a euro government bond perspective, the carry and roll-down in the shorter/middle part of the curve outweighs the small pick-up in yield for the longer-dated bonds,” he says.
Bank investors are expected to increasingly buy covered bonds given the lower risk weighting under Basel II. “At the moment, it is expected that a lot of banks will move to the foundation approach under Basel II. This means that the risk-weighting will change from 10% or 20% to around 4%,” adds Dekker.
Asian central banks, which currently buy into the Pfandbrief market, will also look at other jurisdictions as legislation for covered bonds improves across a number of countries.
In order to comply with European legislation, Denmark, for instance, is in the process of reformulating its Mortgage Bonds Act legislation and introducing a Covered Bond Act instead. Since the inception of Danish mortgage bonds more than 200 years ago, there has been no single default, says Kasper Ullegard, chief portfolio manager, head of foreign exchange, government and mortgage bonds at Danske Capital.
To qualify as a covered bond, what were formerly known as Danish Mortgage Bonds will have to fulfill additional criteria (most importantly complying with the LTV limit on every single loan instead of the loan pool). “The additional requirements are expected to at least uphold the current pricing and, if anything, richen the pricing of mortgage bonds issued under the new Covered Bond Act,” says Ullegard.
Overall, covered bond supply has not been as high as expected this year compared with 2006. “We thought there could be more than €200bn in overall covered bond supply, but now it seems like to be in the range of around €180bn or so. Though it is too early to come out with such a forecast, so far, supply has been definitely below expectations despite strong demand. One reason could be the increase in the LTV ratio offered by banks owing to fierce competition in the Spanish market place,” says Linder. Spanish banks/originators attempt to fund mortgage loans through RMBS instead of covered bonds to get the high LTVs off balance sheet, as they would need more capital for that under Basel II, he adds.
As it is getting increasingly difficult for people to be successful in the public finance business, public-sector covered bonds are losing their market share to mortgage covered bonds. And this trend will continue, say fund managers.
Asset managers also predict an increase in structured covered supply. “I am indifferent to it. I like anything that offers a little bit more spread. So, if the structuring results in a few more basis points in spread, I like it,” says SSgA’s El-Shaer.
“As a product, covered bonds could become the backbone of the European fixed-income market. It used to be the largest part of the German fixed-income sector and it will become even more important in other new jurisdictions, such as Spain, France and the UK. Since the mortgage business is an important, growing part of banks, issuers will rely more and more on the covered bond market for refinancing as they are cheaper to finance and an interesting vehicle,” sums up Linder.