Playing second fiddle
The resurgent covered bond market, with a few exceptions, has belonged to established names with only a handful of new issuers. This is set to change as new legislation arrives giving investors greater peace of mind about the quality of cover pools. David Rothnie reports.
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Despite a glut of issuance, first-time issuers have been relatively rare, particularly in the face of ongoing eurozone debt worries. Investors are not interested in snapping up new names but are more focused buying covered bonds from established names in established markets. Safety is the name of the game
The main supply of late has come from core European markets rather than the periphery, and the emphasis is on safety and established names rather than yield or first-time issuance” said Jeremy Walsh at Royal Bank of Scotland. “These have met with exceptional demand and in many cases have priced without any new issue premium.
The French market, which had been quite congested at the start of the year, is very well sought after. It has seen a spate of deals that have tightened significantly during the bookbuilding process, and also subsequently in the secondary market. French covered bond issuance has topped €50bn so far in 2011, and there is no sign of the pace slowing down.
The French market has seen a flood of issuance in reaction this preference among investors for covered bonds from core European markets. But it has also received a boost from the new legislative framework of obligations de financement de l’habitat, which has formalised the market. “It the same assets, wrapped the same but investors have been calling for legislation and now they have it,” said one syndicate banker.
“While it’s true that some banks have accelerated their funding plans given the recent volatility, the level of covered bonds issuance has been extremely healthy and demand has proved to be very strong,” said Ralf Grossman, global head of covered bond origination at SG.
On May 31, frequent French issuer Caisse de Refinancement de l’Habitat sold a 10 year €1.25bn issue in 30 minutes that offered a 4% coupon. The deal, which priced at mid swaps plus 63bp, attracted €2.7bn of demand according to one banker on the deal. A week previously, Societe Generale SFH sold its €1.5bn five-year covered bond at mid-swaps plus 43bp and attracted €3.7bn from 150 orders – the largest order book for a French issuer so far in 2011.
The transaction was SG SFH’s inaugural covered bond and the second euro-denominated benchmark issue launched under the new legal framework. The new rules removed the 35% cap on the use of guaranteed home loans in cover pools and introduced a 2% minimum over- collateralisation requirement. They will fit the criteria posed by the UCITS directive, which will enable deals to be eligible for repo at the European central bank.
Last month Credit Suisse attracted US$4bn in orders for its US$1bn five year inaugural dollar covered bond, which tightened in the secondary market. This was followed by Norway’s Sparebanken, which priced US$1.25bn 5-year covered bonds rated Aaa/A. Sparebanken’s paper offered a yield of 2.75% representing a decent pick-up over the five-year Treasury equivalent of 1.59%.
The US market has seen some inaugural issuance as investors show a greater demand for the asset class. Andrew Porter, global head of covered bonds at HSBC, said: “In the US investors are being tempted to buy covered bonds by the reduction in Triple A issuance from the government sponsored enterprises as well as the tight spreads in the Triple A ABS market.”
The US, Australia and Canada are all seeking to introduce covered bond legislation in 2011 in a move that will boost issuance even more (see separate stories). In the international market, Canadian banks have been responsible for selling the vast majority of the US$30bn dollar denominated covered bond supply last year and have continued to lead issuance in 2011.
Porter said: “The real drivers of issuance have been the incremental demand from new investors entering the euro sector and the increasing interest from the US 144a, sterling and Australian dollar markets.”
The covered bond market has continued where it left off in 2010, when worldwide issuance of the paper reached US$356.5bn, with banks and investors seeking havens during the sovereign debt crisis. This year, with issuance more broadly-based by geography and more countries developing legislation to turn covered bonds into a more mainstream asset class, investors are still clamouring for the ultra-safe instruments.
“The banking and sovereign debt crises have created a shift in thinking about what constitutes risk-free,” said Ted Lord, head of European covered bonds at Barclays Capital. “Nothing is risk-free, but covered bonds have maintained an ultra-safe quality over the past centuries. There has not been a default since covered bonds were created in 1769 and investors like the fact that the cash-flow is ring-fenced. Investors are looking at investing in covered bonds at the expense of certain government bonds and we have seen spreads come in for banks with good business models.”
There are likely to be more new issuers coming in the future. Banks are turning to the covered bond market as an alternative to central bank funding. With the asset class enjoying certain regulatory benefits under new legislation, their popularity is expected to continue.
In the first five months of the year, there has been €126bn in issuance from euro-benchmark borrowers and US$18.5bn from the dollar market. In total, issuance has jumped by 30% on the equivalent period in 2010 and bankers predict a record year. Italian banks have accounted for double the amount of issuance that they did last year, even accounting for a drop-off in activity during April due to sovereign debt issues. At the end of May UniCredit, along with Spain’s Santander, reopened the covered bond market for peripheral issuers, but bankers stress investor preference remains at the core.
The UK has seen more than £6bn of covered bond issuance this year, compared with virtually zero since the financial crisis. In April, the UK Treasury put out a consultation paper on the UK’s covered bond market with the aim of raising transparency in the UK covered bond market and making the UK regime more readily comparable with European peers.
According to the Treasury, the aim of the consultation, which closes on July 1, is to “increase the appeal of UK covered bonds to investors, making it easier for banks and building societies to raise funding in order to lend to households and businesses.”
Covered bonds are coming of age because they are viewed favourably by regulators putting together the post-crisis legislative framework. Bank Investors are increasingly investing in covered bonds due to their high liquidity cover ratio under Basel III. Under the Basel requirements covered bonds have been deemed the only bank asset that is eligible for liquidity buffers.
Secondly, covered bonds are given privileged status under the new solvency II regulations covering insurance companies, making them an active investor class. Thirdly, the focus on bail-in legislation is driving credit investors to the safety of secured credit.
Covered bonds sate the regulator’s demand for banks to secure stable long-term funding under Basel III, which calls for 40% of their liquidity buffers to contain level two assets.
Despite the rise of covered bonds, they remain a relatively illiquid asset. While banks and insurers will hold more of them, new regulations could also stem the tide of issuance when they finally come into force. Although Basel 3 allows the use of covered bonds in the liquidity buffer, the extent to which it can be filled with covered bonds will generally be capped at 40%, with the bonds subject to a cut in value. The minimum liquidity requirement is set to be introduced at the start of 2015.
The European Union, which is seeking to introduce its own update to the capital requirements directive in line with Basel III, is reviewing the 40% rule because of the likely impact on smaller European banks, which rely more on covered bonds as a source of funding. However, protestations from the Danish government – which has said that Basel III will force banks to dump covered bonds – will not result in removal of the cap altogether when the EU reports back before the summer.
“There is certainly not an infinite supply of covered bonds,” said Porter. “The EU Commission Working Group’s proposals for bank recovery and resolution are due for release in June and we expect this release to focus attention on the constraints on banks’ ability to increase their levels of asset encumbrance. This will likely increase the scarcity value of covered bonds.”