Thursday, 19 July 2018

Pfandbriefe/Covered Bonds 2007: What a difference a year makes

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The Spanish covered bond market has enjoyed something of a renaissance in 2007, as supportive supply/demand dynamics have underpinned spreads in a sector that has outperformed many of its peers. The market also has another reason for optimism, as proposed improvements to the Cedulas framework are awaiting the green light from the Spanish parliament, a scenario that should lend further support to spreads in the future. Andrew Perrin reports.

The situation in the Spanish covered bond market is in stark contrast to a year ago. Then, criticism was leveled at many Spanish issuers as a result of what some viewed as a lack of clear and dependable guidance with respect to the timing and volumes of issuance. Indeed, it was around this time last year when the outlook for Spanish Cedula was cloudy at best. A huge influx of supply had put pressure on spreads and at times had pushed investor demand to its limits. This was especially evident at the long and ultra-long end of the curve, where around 75% of Cedulas supply was targeted in the first half of 2006. This often forced borrowers to pay a sizeable premium over secondary market levels in order to command sufficient interest.

What a difference a year makes, as the cautious approach adopted by Cedulas issuers since the latter part of last year has gone some way to help the jurisdiction shed its “cheap issuer” tag. This is reflected by the historically tight levels at which bonds have been trading for much of the year and is well illustrated by the 10-year benchmark from AyT Cedulas that was launched in March at mid-swaps plus 7.5bp, before tightening in to a low of mid-swaps plus 3.5bp.

While lower than expected and more evenly distributed supply has been the catalyst behind the strong performance of Cedula this year, the market also boasts the prospect of a more solid legislative framework, initially proposed by the Ministry of the Treasury towards the end of 2006 (see separate box for details of the proposed changes). According to Florian Hillenbrand, covered bond analyst at UniCredit, this has yet to be priced into Cedulas spreads and should offer further potential to perform when parliament gives the new legislation the green light.

“The situation in Spain could evolve similarly to what we have seen in the Swedish market with both having comparatively weak frameworks. This was enhanced In Sweden by transferring old outstanding bonds into the new framework, which meant a qualitative quantum leap for investors in terms of credit quality and they subsequently enjoyed a significant tightening of spreads. Should this be replicated by Spanish law makers, a scenario that would appear to make sense, then we see no reason why Cedulas spreads should not continue to tighten in line with Swedish covered bonds, assuming that the supply/demand dynamics remain favourable,” he suggests.

Ted Packmohr, senior covered bond analyst at Dresdner Kleinwort agrees that the “legislative changes have barely been priced into current spread levels that have been dictated by Spanish issuance volumes that were down by around one-third in the first four months of this year. This compares to most other jurisdictions that are around flat or have increased during the same period and discounts additional flow from the emergence of new markets such as the US and Sweden.” He was also keen to point out that the overall market has been supportive of higher-yielding assets, having been trading relatively negatively on an outright basis at the end of the first quarter in particular. “Ten-year Cedulas offering a psychological yield of 4.50% have been very eye catching in this environment,” he says.

However, while acknowledging the obvious advantage that the proposed changes will offer issuers and investors alike, he did not share the view that the new legislation should automatically pave the way for spreads to tighten further. “Spain is just one of a number of countries that is improving or amending its existing framework, so we are somewhat sceptical as to whether this alone will offer the potential for ongoing out-performance,” he notes.

Soft landing anticipated

If there is a cloud on the horizon for Spanish covered bonds, it is probably the prospect of fall-out from a slowdown in the domestic housing market, where price inflation slowed to 7.24% in the first quarter this year, down from 9.11% and 9.83% the previous two quarters. This followed rhetoric from the Spanish central bank suggesting that retail property prices are around 30% overvalued. While Cedula did feel the pinch from the resulting property sell-off and, to a lesser extent, construction stocks, this was not only negligible in the greater scheme of things but also very short lived. By the end of the week the sell-off began, jumbo Cedula had regained their initial 1bp-2bp widening. This was consistent with the widely held view that, while slowing, the property market is heading for a soft landing.

“Spanish banks have a relatively high creditworthiness, as reflected in their senior ratings, and unless the perception shifts and investors begin to fear a crash and its adverse impact on the economy, then spreads are unlikely to suffer. There is also the Basel II effect to consider, which requires higher risk capital to be provided for loans with higher loan-to-value (LTV) ratios. Given the robust rise in the property market, LTVs will likely have risen likewise. Hence, Spanish banks use the opportunity prior to Basel II to securitise their high LTV loans into mortgage-backed securities (MBS) rather than use them for Cedulas issuance. This is a trend that has already been in evidence, the upshot of which supports the likelihood that Cedulas supply will remain orderly for the foreseeable future, which should in turn remain supportive for spreads,” notes Packmohr.

Hillenbrand agrees, saying that crucial for the outlook of the Spanish economy will be if the housing market correction reverses the declining trend in the unemployment rate, the construction sector having been a key driver behind the employment boom. However, for the time being, the story of the soft landing is still valid, as local governments’ policies concerning building permits become more careful and house price development support that scenario.

“In Madrid, the Comunidad Autónoma, which plays the role of a forerunner in terms of price development, reported real estate appreciation rates of 4.46% in Q1 2007 after 6.11% and 7.22% in the previous quarters. Not a single province reported declining house prices and we are talking about 63 provinces in 18 comunidades. The highest appreciation rate (excluding the North African exclaves of Ceuta and Melilla) was reported by the north-western province of Coruna in Galicia with a 14.2% house price increase per year. This shows that the housing market, while slowing, remains in good shape and supports expectations of a soft landing.”

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