Pfandbriefe/Covered Bonds 2007: Market manages expectations
Expectations for covered bonds this year for the most part centred on just two things. Buoyed by previous experience, participants braced themselves for record volumes, while a proliferation of covered bonds in the US was eagerly awaited. However, as the end of the second quarter draws closer, it looks as if expectations will have to be reassessed. Rachelle Horn reports.
After a record-breaking 2006 that saw volumes increase some 30%, the market was expecting big things from covered bonds this year. According to data from Thomson SDC, €184bn equivalent of jumbo issuance priced in 2006, and right up to the very end, the market continued to be dazzled by new entrants and jurisdictions.
In contrast, 2007 has so far brought less in the way of glittering new markets and, if current supply is anything to go by, covered bond volumes may only exceed 2006 by the most conservative of predictions.
With forecasts ranging from €185bn to €230bn for this year, dwarfing 2006 at the top end, the first quarter all covered bonds (all currency) volumes were actually down 18% compared with the same period the previous year. As of mid-May, however, supply finally appeared to be playing catch-up, but with volumes still down 14%, the market may not reach analysts’ more optimistic expectations.
While the total outstandings in covered bond market as of the start of 2007 totalled a phenomenal €1860bn, it is the jumbo market that continues to be the major focus for international investors. However, with virtually half of current supply now being launched in non-jumbo format, this is not a segment that market participants can afford to take lightly.
According to Ted Packmohr, an analyst at Dresdner Kleinwort, mortgage-backed covered bonds should continue to dominate and increase their share of the jumbo market.
In terms of geographic make-up, while Germany continues to take a large slice of the pie, its dominance has declined dramatically recently. Although issuance volumes have remained relatively stable over the past five years, the internationalisation of the market dictates that it plays less of a central role than once it did. While Pfandbriefe accounted for around 40% of supply in 2002, a steadily shrinking market share means that percentage is nearer 28% so far in 2007.
And with volumes in the remaining covered bond markets soaring, it is Spain that has led the charge: a total of US$339.7bn was issued in 2006, representing an astonishing 198% increase to the amount issued in 2002.
The promise of liquidity, attractive spreads and diversification has long made covered bonds a firm favourite with investors. In addition to an excellent track record, the proposition of paper from new names and new markets, improved legislation and Basel II have all served to encourage buyers to come on board.
According to analysts at ABN AMRO, there are five core investor groups that buy into the product, all taking a different view as to where it sits versus government and agency debt and the securitisation market.
Banks have historically played the major role, buying on average 40% of jumbo transactions. The risk-weighting of covered bonds is therefore important, although pressure on banks from Basel II/CRD in 2007 will likely be more limited than at present.
Real-money investors such as pension funds, insurance companies and investment funds also account for nearly 40% of demand on average. "Real-money investors are usually government bond benchmark based or aggregate benchmark based," say the ABN AMRO analysts. "They invest in covered bonds because of the yield pick-up they gain versus government or agency bonds."
The market has also attracted respectable demand from central banks, estimated to stand at just over 10%. Many central banks follow a strategy not too dissimilar from that of the real money investors, although their slightly different focus means that they place a greater emphasis on credit and rating quality and the track record of the assets. While real-money investors tend to have a preference for longer-dated maturities, central banks invariably prefer short and medium-term tenors.
While German still constitutes the largest nation of covered bond investors, the geographical diversification seen on the supply-side has unsurprisingly been closely mirrored on the buy-side as accounts seize the opportunity to buy domestic credits. Most notable on this score have been Spain, Ireland and the UK.
Home run still awaited
This provides further evidence that the emergence of a domestic market in covered bonds can have a profound effect on investor participation, and nowhere is this expected to be more-true than in the US. Similar to the situation surrounding jumbo issue volumes, the arrival of a US covered bond market has yet to live up to the hysteria.
So far, only Bank of America and Washington Mutual have issued US covered bonds, with a collective volume of €10bn, and the market is still expecting two more US institutions to debut this year, namely Countrywide and Wachovia. In the case of US dollars, issuers such as DEPFA ACS Bank and HBOS have played an important role in penetrating a rigid investor base, which is yet to embrace the product, even after 10 years of trying by the sell-side. Spanish borrowers are now set to throw their weight behind the push, both Caja Madrid and AyT Cedulas Caja announcing US dollar Global for pricing within a matter of weeks. However, the major event that covered bond observers are still waiting for is the first US borrower to issue in US dollars.
Elsewhere, Spain's Caixa Galicia and Denmark's Achmea have unveiled their first covered bonds this year. Other banks in Denmark, Finland, France, Italy, the Netherlands, Norway, Sweden and the UK, to name but a few, are expected to follow suit. Move further east and
Turkey is in the midst of preparing its legislation and rumours of Asia looking to get in on the act continue to do the rounds.
If new markets and issuers are not enough to keep observers busy, 2007 should also see an increase in borrowers choosing to issue outside of their legal frameworks and offer covered bonds through contractual agreements. BNP Paribas is perhaps the most famous example. The bank chose to eschew the long-standing Obligation Fonciere law in favour of its own structure and, if rumours are to be believed, it will not be the last major bank in France to do so.
And in Germany, Landesbank Berlin is looking at taking a similar path. With the Pfandbrief considered by many as the backbone of covered bond laws, the issuer encountered some high-profile opposition, however, despite the politics; LBB could emerge in the coming months.
With agency, sovereign and supranational supply on the decrease, covered bonds continue to benefit from strong demand and a general lack of competing Triple A rated issuance. Consequently, spreads remain at their historical tights, which is particularly true in the case of Pfandbriefe, although it is the Spanish Cedula that have been the outright winners. Despite the current housing woes in Spain, supportive supply/demand dynamics have underpinned spreads in the sector, which has outperformed many of its peers.
The withdrawal of Goldman Sachs from the NewEuroMTS platform in January this year also brought to the fore a long-standing disquiet among covered bond traders. In addition to criteria regarding such things as size, jumbo covered bond standards also contain a market-making obligation pertaining to the involved syndicate banks.
But while the market-making obligations are therefore a pre-requisite in the jumbo covered bond market, not all are in favour, some saying they provide nothing more than forced liquidity. "It does not make sense to provide a two-way price to our competitors," says one disgruntled trader. Citing the showing of two-way prices on MTS, he continues: "You do not win a trade bidding an MTS bid or offering an MTS offer. In the current environment, the only winners are the borrowers, the customers and MTS."
With tight secondary margins in this market, one market-maker declared that he would rather the primary business gave up a basis point when pricing a deal than for him to be forced to quote the paper on an electronic platform in the secondary market, because "it invariably costs us more".
A lot of the controversy centres on the five-hour market-making rule. As well as tweaking prices, most pointed out that the cost of market making lay more with man hours and resources. One trader went as far as to state that, once his company’s five hours was up, "we switch it off and focus on proper trading".