Thursday, 19 July 2018

Play it safe, play it short, play it Pfandbriefe?

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While other covered bond jurisdictions have fallen from grace, the German Pfandbrief levels have barely flinched, significantly outperforming its peers since the onset of the market turmoil. But can the asset class continue to decouple from the general market trend? Rachelle Horn investigates the fundamentals underpinning its success.

Though the traditional mainstay of the German Pfandbrief has been somewhat overshadowed by the hype of new covered bond entrants over recent years, the performance of this asset class during the credit crisis has undoubtedly reaffirmed its position on the centre stage as the best there is in the covered bond world.

During the course of the past six months, the secondary covered bond market has continued to delve in and out of panic territory; and in the context of widening credit indices and swap spreads, at nearly 20bp over mid-swaps the iBoxx indicator of covered bonds is now at its widest levels versus swaps since 1999. But in spite of this, any widening of German covered bonds has so far been relatively negligible.

While the movements of German Pfandbrief spreads have stayed confined within a few basis points, the covered bond spreads of Spain and the UK have widened by anything up to 60bp since August 2007. The spread differentials between the different jurisdictions in the covered bond market are therefore at their widest levels yet.

And when considering the spread levels of the Pfandbrief compared to the rest of the covered bond market, the immediate questions that spring to mind are: can such tight levels are realistic in light of the movements in the wider market; and what direction can spreads feasibly take going forwards? Even more important, however, is the fundamental question of how long the covered bonds of German banks can withstand the contagion from the credit implosion.

But the performance of the Pfandbrief has not just been limited within the covered bond market. According to Bernd Volk, a director in Deutsche Bank's research department, some public Pfandbriefe even trade through German federal states. This does not necessarily make much sense, he admitted, but "it does show the strong market technical's behind this product."

And where Pfandbriefe have remained relatively stable against swaps over the past two months, peripheral governments have not. Non-core sovereigns such as Italy, for example, have underperformed swaps by approximately 10 basis points in comparison.

"The entire market is in a liquidity trap and everyone wants to hold liquidity at any price," explained Florian Hillenbrand, a vice president in UniCredit's covered bond and agency research department. "The outcome of such an extreme situation, where you can practically involve yourself in heavy buying of Italian bonds and refinance through Pfandbrief – and even get positive carry – is an anomaly. It is not fundamentally justified."

Still, as Jose Sarafana, head of covered bond strategy at SG CIB pointed out, the question of performance depends on what you compare the Pfandbrief to: "If you say Pfandbriefe have traded historically expensive to Italian government bonds then you are probably right, but the market is in crises mood and people want to reduce their risk."

Germany has not managed to stay entirely immune from the trend of increasing differentiation between mortgage and public sector covered bonds. Before the crisis this was negligible in German Pfandbriefe, but post turmoil it has been worth anything up to 7bp in some cases.

Regina Koelsch, a senior covered bond strategist at UBS explained that at minus 9bp, the iBoxx five-year public sector Pfandbrief index is around 1bp to 2bp wider than the levels of a month ago. The five-year mortgage Pfandbrief index, on the other hand, has widened about 5bp to 6bp over the same time period.

Though public sector Pfandbriefe are the clear winners in terms of performance, analysts do not generally expect a sizable widening of mortgage Pfandbriefe. "You do not have the same credit drivers as in the UK or Spain where investors are concerned about the deterioration of the residential mortgage market," said Koelsch. "Plus, the mortgage pools of some of the German issuers' exhibit a greater diversification across countries."

The last man standing

Despite the fact Pfandfbriefe look extremely tight in the context of the remaining covered bond market, analysts concur that the downside risks are limited, simply because of the fundamentals backing the product.

The fall in jumbo issuance is one such factor supporting its spreads. In essence, German Jumbo issuing activity remained on a downward trend in 2007, which, combined with high redemptions, has meant that the Pfandbrief market continued to shrink. In September 2007, the total outstanding volume (including non-Jumbos) fell below €900bn for the first time since 1998, while the German jumbo segment, currently with an outstanding volume of €310bn, is now only €67bn ahead of the Spanish.

SG's Sarafana forecasted approximately €37bn of Pfandbrief supply for 2008, which in the context some €65bn of Pfandbriefe due to mature results in a negative net supply of around €28bn, according to the analyst.

But in addition to supply, Sarafana added Pfandbriefe typically have shorter maturities on average, which in the current environment is safer for investors. "But I do not necessarily think it is a credit question of one bank being safer than another," he explained. "Above all, it is a question of very low net supply and past stability. There is essentially too much demand for too little bonds".

And despite the fact that there will be pressure on German banks in 2008, particularly in light of the negativity surrounding the Landesbanks, Deutsche Bank's Volk said the banking system as a whole has specific strengths. "The German savings and Landesbanks benefit from a strong deposit base, and in addition to this, the savings bank group is a net funding provider which is a major strength given the current wholesale funding conditions," he said. As such, Volk added that even in the event of spread widening, German Pfandbriefe are unlikely to see spreads losses comparable to the UK, Spain or Ireland.

While it is hard to argue against the fundamentals, traders on the street however are less bullish on the current levels. Before the gentleman's agreement between traders put a halt on inter-dealer market making in early March, spreads of Pfandbriefe had seen a widening to swaps by 2bp to 4bp in the previous weeks.

"The Pfandbrief is not some magic asset class” said one covered bonds market maker. “It has been short in the street but we are actually quite negative of Pfandbrief spreads and I do not think that their current trading levels are justified," he added.

Another market maker echoed the view. "We are in the middle of a credit implosion which should be felt across the spectrum, and that includes the Pfandbrief. We have seen peripherals such as Greece trade at 14bp over swaps in 10-years. We are now starting to see clients on the sell side so I think spreads can go wider," he said.

In its latest marketing campaign, the Association of German Pfandbriefbanks (vdp) used the slogan "simply Pfandbrief - simply good" to sum up the performance of the product.

"Even when times are rough, its special brand of safety and high market share make it a safe haven for investors and a reliable funding source for issuers. Conservative credit standards mean that subprime risks are ruled out," said the association. But, in addition to the conservative credit standards and well flagged strength of the Pfandbrief law, another supporting factor crucial to the Pfandbrief market is the unrivalled domestic bid for the product.

"If you look at how spreads throughout the entire covered bond world widened, one might be of the opinion that Pfandbriefe require some basis points adding to the trading levels," said UniCredit's Hillenbrand.

"However, if you take the spread levels and compare with the domestic bid between the different jurisdictions then you will note a pattern of stability where German paper, followed by French and Nordic (Swedish in particular) still show stability, whereas Spanish and UK covered bonds have suffered," he added.

Indeed, it is not uncommon to see over half of the allocations for Pfandbirefe issues place inside Germany, the recent €1bn three-year issue from Landesbank Berlin for example saw 51.5% place domestically.

However, the reputation of the product is not confined to its domestic investors. "The status of the Pfandbrief is so strong both within and outside the German boarders that any widening is taken as an opportunity to buy," said Hillenbrand.

With the clear flight to quality towards the Pfandbriefe, few expect a risk of any notable spread widening, though the potential to the upside is also limited. "Even though all new issues in the Jumbo Pfandbrief performed well this year, further new issues will continue to have to pay a pick-up in this market environment," said Volk.

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