Thursday, 16 August 2018

Pfandbriefe/Covered Bonds 2007: Structured momentum

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Structured covered bonds have seen exponential growth since their inception in 2003. With a number of issuers now choosing to eschew even the most revered covered bond laws, the debate concerning structured covered bonds has never been hotter. Rachelle Horn reports.

Think back just five years and you are taken to a time when covered bond funding was a playground reserved only for financial institutions from countries with a covered bond law in place. But with structured issuance now accounting for 32% of the supply, it is hard to believe, looking back, that access to this market was just a pipe-dream for the many.

Nonetheless, times change, and after the door to structured covered bonds was opened by HBOS in 2003, prejudices soon began to wane. The market has not looked back since.

However, despite structured covered bonds now giving RMBS and legislated covered bond volumes a run for their money, the perceptions of the traditionalists versus those of the revolutionists still remain a source of disparity, even four years down the line.

Moody's Investors Service defines a structured covered bond as (i) a covered bond where securitisation techniques have been used to enhance the rating of the covered bonds, or (ii) a secured bond issued against a pool of assets in a jurisdiction where no specific covered bond law has been established.

Structured covered bond programmes have been successfully introduced in several markets, including Spain and Denmark, where a covered bond law is already in place, and with low-cost funding a priority for most originators involved in relatively low-margin mortgage and public sector lending, Moody's believes that the structured covered bond market will continue to expand.

Nevertheless, despite most European countries making strides to accommodate the structured covered bond product, at no time has the debate ever been more heated than in the past six months. As the staunchest supporters of the traditional covered bond, news that financial institutions in Germany and France were planning to turn their backs on their respective laws in favour of their own structuring predilections sent shock waves rippling through the market. But far from just plain attention seeking, there remains a strong argument that issuers need more flexibility than a robust law can offer.

Opinions divided

Perhaps the most political of these cases has been the move by Landesbank Berlin (LBB), which rocked the domestic German market when it recently announced that it will reject the Pfandbrief framework in favour of its own structure.

With origins dating as far back to the 1700s, the Pfandbrief has long been marketed by its domestic professionals as the backbone of the covered bond universe. However, it has been well documented that Germany's dominance of the international covered bond stage has come under challenge over recent years.

So, far from embracing the new development, the reaction in the domestic market has not all been positive. The Association of German Pfandbrief Banks (vdp) has openly spoken out against the need for structured covered bonds. Louis Hagen, executive director of the vdp and chairman of the European Covered Bond Council, explains: "We are working towards a homogenous and deep market that other countries are still only starting to build. While splitting up the German covered bond market may add to diversification, we feel that the added heterogeneity will take away potential liquidity."

The vdp maintains that a contractual agreement is no way comparable to the safeguards established under the German Pfandbrief Act. As Sebastian von Koss, an analyst at BayernLB points out, "this includes covered bonds from the UK, the Netherlands, the US and France’s BNP Paribas".

And with Pfandbriefe now trading at historically tight levels, some investors are decidedly upbeat about the prospect of a new structured segment and the potential spread pick-up over their German cousins. Still, the proposed LBB structure continues to cause a political stir in the domestic market, with some questioning why the institution would deviate from the sacred Pfandbrief format, in spite of the apparent difficulties faced by the smaller savings banks.

Unsurprisingly, the majority on the sell-side seems positive about the prospect but analysts are now deliberating exactly where the trade-off between maintaining a high standard of Pfandbriefe and improving the accessibility to the framework now lies. "In my view, the Pfandbrief law should be less strict and more yielding," said one.

Indeed, so political is the situation, a number of sources have said that some German underwriting houses did not even bid for the mandate for fear of upsetting the staunchest of Pfandbrief supporters.

In a scenario similar to that in Germany, French issuers of Obligations Foncieres are well-established borrowers in the jumbo covered bond market. As such, BNP Paribas' announcement that it would issue outside of this framework was met with some scepticism at first.

However, BNP Paribas' debut triumphed with a book several times oversubscribed, a sure sign that investors are by no means negative towards structured issuers compared to those based on a covered bond legislation. In fact, its second foray issued in March even saw a notable growth in investment from Germany, a sure sign of acceptance.

Though there will likely be a dip in structured covered bond volumes when the UK law is finalised, it is widely expected that structured covered bonds will continue to grow as in recent years. However, the spread differential between covered bonds within a legal or contractual framework continues to converge. As Tim Skeet, managing director of EMEA debt capital markets and head of covered bonds at Merrill Lynch points out: "The pricing will still be driven by the law-based product and, while some structures may piggy-back on the trading levels of those issues, the question is one of liquidity. If there is a credit fall-out, will one asset class be impacted more than another?"

Despite the potential benefit of a new asset class, the fragmentation of structured covered bond markets will invariably mean more credit work for investors and, as the world of covered bonds becomes increasingly opaque, one debate that has continued to run in Europe is the call for a clear definition.

This call for clarity has also been echoed by the investor community. "The borders are expanding and I think there is a danger of undermining the covered bond brand-name," says Torsten Strohrmann, fixed-income fund manager at DWS.

But while there is a trade-off between the homogeneity of the asset class and diversity of structures, "in the current cycle, investors appear to accept that commercial contracts can offer levels of investor protection comparable to formal law-based regimes", according to Skeet.

Though the Triple A rating can mask a host of vulnerabilities, "the challenge for the industry will be to ensure that investor protection is in no way compromised by the desire of issuers to seek flexibility in terms of cover assets or structures", adds Skeet. But while the consensus appears to be ‘so far so good’, Skeet stresses that analysts, trade associations and investors will have to remain vigilant.

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