Pfandbriefe/Covered Bonds 2007: US set for take-off
The expansion of the non-euro covered bond market is a developing theme, with the US dollar sector the main beneficiary of the trend so far. While recent US dollar deals have suggested this may pose a real challenge to the dominance of the euro, its progress has been beset by a number of initial obstacles. An increase in issuance volume seems to indicate that these hurdles are slowly being overcome, however. Michael Winfield reports.
Many reasons have been put forward to explain the relatively slow rate of growth of the US dollar-denominated covered bond market. “Some of the delays in this happening have been attributed to the need to set up a programme for issuance and the costly legal work associated with this,” says Torsten Elling, head of covered bond syndicate and trading at Barclays Capital in Frankfurt. “Does it all make sense in the context of extending the investor base? The fact that there was US$7.5bn of jumbo covered bond issuance in 2006, compared to US$7bn in the first three months of this year suggests the answer is yes.”
European issuers have also had to overcome other regulatory hurdles. One example is Spanish issuers wanting to issue in US dollars having to await the completion of new Spanish covered bond legislation, although this is almost complete and the likely first issuer, AyT Cedulas, has already mandated Barclays, JPMorgan, Morgan Stanley and Nomura for a US dollar likely to emerge late in Q2 or early in Q3, while Caja Madrid has also expressed an intention to raise US$2bn–$3bn, most probably in June, Barclays Capital, JPMorgan and Morgan Stanley joining Cajam itself on the top line.
As far as the other side of the coin is concerned, that is to say US borrowers coming to the euro market, the question of ECB eligibility of covered bonds for repo purposes has required resolution. This question stemmed from the fact that, as structured products, most covered bonds are issued by a special purpose vehicle, not by the bank directly. “Although this has now been resolved, it has been followed by fears associated with contagion from the sub-prime lending sector in the US in recent months,” says Ralph Berlowitz, head of liquid credit syndicate at Deutsche Bank. But some of the more fundamental factors impeding growth have related to the deals that have so far been completed in US dollars.
The recent 10-year deal US dollar deal for HBOS in February is likely to silence some of the doubters influenced by the hiatus that followed the issuer’s inaugural five-year deal in November 2006. That transaction set a precedent for a European borrower raising capital in the US market but failed to establish this type of security as an asset class in its own right. Much of the concern centred on the depth of distribution, despite 76% of the US$2bn security being placed with US investors. The fact that this was made up of only 19 accounts taking down average tickets of US$80m did not convince everyone that this would establish a new sector of the market.
HBOS’s US$3bn 10-year deal follow-up, on the other hand, enabled it to access 50 US accounts with a deal priced at a 17bp-18bp concession to US agencies. It significantly allayed the initial concerns with the take-up falling to an average ticket size of US$47m. The optically generous pricing at Treasuries plus 50bp or mid-swaps plus 1bp was justified by the leads, Citigroup, Deutsche Bank and Morgan Stanley, as the means of developing the US account base by offering an attractive pick up to US agencies. It was also a deal that had to be seen to work and the fact that the first trade reported post-break was 2.5bp tighter than launch certainly suggested that this had been achieved in no small measure.
This approach follows the course plotted by a number of non-covered borrowers such as Norway’s Eksportfinans. It has also tapped the US domestic account base by pricing at a concession to agencies, and by leaving something on the table for new investors participating in its early US-targeted transactions, although gradually tightening its levels over time.
The DEPFA experience
Another high-profile issuer, DEPFA ACS, has been building up a debt curve for many years with increasing degrees of US penetration and recently successfully completed the extension of its curve out to the 30-year point. Even before this deal, DEPFA boasted the best-established 144a covered dollar yield curve, but only out to 10-years. A five-year transaction launched in June 2006 at 46bp over Treasuries resulted in a very credible 33% US placement, more than twice that of its 10-year of October 2005 at plus 44bp, when just 15% of the paper found US takers.
DEPFA’s attraction in dollars is, in part, attributable to the fact that, as a public sector borrower, it has a much higher profile with the Asian investor base, says Chris Lees, former head of the public sector borrower syndicate at Citigroup. But the 30-year deal saw 88% placed with US accounts, the remainder being sold internationally. Of the allocated book, 79% went to accounts that had not taken part in DEPFA’s dollar benchmarks since the programme was re-launched in 2004. “This is the real agency trade that the market has been looking for,” says Tim Skeet, managing director of EMEA debt capital markets and head of covered bonds at Merrill Lynch. “This deal will define how the US market views this asset class and the positioning of the product towards credit or rates.”
Managed by Goldman Sachs, Merrill Lynch and Morgan Stanley, the US$1.25bn 30-year sold at the equivalent of mid-swaps plus 2bp and was targeted squarely at the US account base. It provided tangible evidence of the market’s development and investor sentiment regarding US dollar covered bonds and, coming from a public sector-backed entity was able to succeed in a maturity bracket that, away from governments, has previously been reserved for the likes of the EIB and KfW.
The borrowing rationale was fairly unique “as the transaction had no basis in arbitrage-driven considerations because we operate on match funded basis,” says Julia Hoggett, head of capital markets at DEPFA Bank Group. This means that for this exercise “euro funding was not a consideration, despite the European market sometimes being more attractive at some points on the curve.”
“The rationale for pricing the deal at mid-swaps plus 2bp [Treasuries plus 57.25bp] was very clear. This was a very strategic transaction to position the covered bond market in the context of the agency market. In doing the first long-dated covered bond, we were comfortable with the pricing level to get this result,” says Hoggett. “In particular it enabled us to include a number of new accounts that are only just beginning to focus on the covered bond market.”
The deal offered an average pick-up of around 13bp–14bp over comparable agency deals and attracted significant support from rates buyers. Such a concession cannot be relied on in perpetuity, however. As Priya Misra, interest rate strategist at Lehman Brothers says, “I expect that the pick-up to US agencies will be somewhere between 5bp and 10bp [in the future]. However, the question of when will it get there remains a function of issuance and liquidity.”
One major consideration is whether covered bonds will be viewed in relation to SSA paper or, like US agencies, as an alternative to Treasury risk. In the long term “the Street is generally moving towards trading covered bonds off the agency desk,” adds Misra. Currently, it seems as if covered bonds still fall between the desks in the US, according to Robert Plehn, head of securitisation and covered bonds at HBOS Treasury Services. “It appears that many investors are now looking at this as a surrogate to agency paper. In the long run, I don’t think the product would be as successful as we would like if investors were to view this as a credit product.”
Following the HBOS deal, Washington Mutual issued its first euro-denominated transaction through ABN AMRO, Barclays and Deutsche Bank. The five and 10-year dual-tranche issue raised €4bn in a deal which, it was thought, would open the door to other US institutions raising capital in Europe and eventually in their own jurisdiction. It attracted huge support and both tranches tightened post-launch by 1bp–1.5bp, vindicating the pricing decisions of the lead managers. The success of WaMu in opening the European market up to US financial institutions, and of HBOS and DEPFA in redefining the boundaries of issuance in the US has not yet led to a deluge of other issuers ready or able to follow their example, however.
Theoretically, both markets have been opened with highly successful, high-profile deals and with the potential to extract cost savings, particularly on the part of European borrowers crossing the Atlantic to raise funds. But the one crucial part of the equation so far missing is that of US issuers raising covered bond debt in their own market, although mandates are reported to have been awarded in this part of the market that may bear fruit in the coming months. Barclays Capital, for example, expects to see US$40bn of supply in 2007, split evenly between European and US borrowers.