With the crisis came a power shift. Investors, once the price-takers, now call the shots in covered bonds. A change in the required new issue premiums has been supplemented by a shift in the placement of deals. But has there been a fundamental shift in the way investors approach this product, or have they just had their hands strengthened by circumstances? Rachelle Horn investigates.
At €16.5bn, May's covered bond issuance already surpassed the total amount of jumbo's issued during the first four months of the year. One could be forgiven for thinking covered bonds have turned a corner in this financial crisis.
Last year was the most challenging year for the covered bond market since its inception in 1995. Secondary liquidity and new jumbo issuance ground to virtual standstill on several occasions. But the remarkable comeback of the primary market since May tells its own story: required new issue premiums are no longer increasing with every deal, which is an encouraging sign of recovery; but a look at the placement statistics of recent new issues highlights how much ground has been lost in terms of investor penetration.
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There have typically been five core investor groups making up this product: banks, central banks, funds, pension funds and insurance companies. Given its origins, it is of little surprise that Geographically, Germans have always represented the largest investor group, followed by Scandinavians, French, Spanish, Irish and UK investors. The latter three had increased significantly in the years preceding the crisis, but now the balance has shifted again.
Besides Germany, the issuers’ home market is still the main sales channel, said Ted Packmohr, head of covered bond research at Dresdner Kleinwort. “On average, 75% of recent weeks’ new issues were sold in the domestic market or German speaking region,” he said. “While Spanish banks also managed to sell a relatively large portion of their Cedulas in the UK, the range of countries featuring in the placement remains fairly concentrated overall.”
Despite the market’s apparent recovery and an ECB induced revival (see next two stories), international interest and trust in this market has not yet returned to pre-crisis levels.
For example, Dexia Kommunalbank's €1bn 3.5% June 2014 public-sector Pfandbrief placed 72% with German and Austrian accounts, while WL Bank, a rare issuer in the jumbo market, issued a €1.25bn 3.75% November 2014 public sector Pfandbrief at a spread of 48bp over mid-swaps. A massive 90% of the deal placed with domestic accounts (see graph).
In new issuance from the French region, Dexia MA's €1.5bn 4.875% 12-year Obligation Fonciere placed 70% with France and 22% with Germany. But not all jurisdictions have the luxury of a robust domestic investor base. The Nordic region, considered part of the “core” covered bond market, has been conspicuous by its absence of late, despite benefiting from a relatively stable housing market. Swedbank's €1bn 4.125% five-year Swedish covered bond priced in late may at a spread of 130bp to mid-swaps, with only 10% placed domestically.
The fact that the Benelux region and Scandinavia play only a minor role in the recent placement statistics illustrates the regional concentration of buying orders, said Packmohr. While both regions once had a clear double-digit percentage share of the books, their current order book share is typically no more than a lower single-digit figure. This is perhaps partly because Norges Bank, once a powerful force in this market, no longer plays such a prominent role.
In terms of investor type, banks dominated as investors of covered bonds in 2008, according to Bernd Volk, a covered bond strategist at Deutsche Bank. They hold a significant amount of covered bonds as collateral for their liquidity transactions with the ECB. Deutsche Bank estimates that approximately 40% of banks placed with banks in 2008, while fund managers made up approximately 27% of demand, central banks 11%, insurance 10% and pension funds 6%.
“The combination of a low risk weighting, high security and ECB eligibility generates significant buying interest from the banks,” said Volk.
For short to medium term bonds, banks have again proved the most important buyer group. Fund managers have become the second pillar of investors, buying 30% to 50% of non German covered bonds said Packmohr.
In longer dated issuance, the share of banks will naturally decline relative to institutional investors, which currently comprise the third investor stronghold, according to Packmohr. “Only under exceptional circumstances did they reach a similarly high share placement before the crisis. The fact that the importance of this investor group has increased so considerably is in part due to low market yields, in our view, which generally boost interest in spread products. Yet, we believe that insurers will focus on highly rated issuers, thus supporting issue placement from the second issuer rank to a limited degree only,” he said.
Back in vogue
According to a recent investor survey conducted by the European Covered Bond Dealers Association, some 64% of investors – including asset managers, commercial banks, pension funds and other institutional buyers – said they still had an appetite for covered bonds and intended to increase or at least maintain their holdings this year. Though the findings also suggested that 53% of the investors were deterred from investing due to the reduced liquidity.
An ECB’s announcement that it will be buying covered bonds has transformed the market (see next story). "The ECB stance has actually reopened the market by rebalancing clients' interests and providing a backstop bid for covered bond holders. This has brought back to the primary market several clients that were staying on the sidelines and waiting for such a signal to re-enter," said Sebastien Gianfermi, head of SAS and covered bond trading at BNP Paribas.
The survey was based on responses from 65 investors from 18 different countries. According to the association, the top three issues to be addressed with almost equal weighting are increased B2C liquidity, improved secondary market transparency and increased inter-dealer liquidity.
Liquidity is key. "We have always regarded covered bonds as a relatively safe asset class – with dual recourse to the issuer and the cover pool – so from this perspective we are relatively comfortable with the product," said Michiel de Bruin, head of Euro government bonds at F&C Amsterdam.
Though the recent revival of new issuance is starting to provide a benchmark for investors, De Bruin stressed he would like to see liquidity reestablished. Covered bonds were marketed for their liquidity, he said. “Market participants should be looking very carefully at how we can restore this liquidity and maintain liquidity when circumstances become difficult.”
An active participant in benchmark covered bonds; DWS Investments stressed its approach towards the asset class has remained constant throughout the crisis. "We still have a three-fold analysis," said Torsten Strohrmann, a senior portfolio manager at DWS. "When deciding whether to invest, we look at the issuer, the cover pool, and the governing legislation."
DWS Investments (the mutual funding arm of Deutsche Asset Management, itself the global asset management service division of Deutsche Bank) had €160bn in assets under management domiciled in Europe as of September 2008. This made it one of the leading mutual funding groups in Europe.
But concerns that the ECB induced correction could be short lived appear unfounded. "Covered bonds have not followed the positive market movement that corporate bonds have benefited from," said Strohrmann. "There has been a lag where this is concerned, but I judge this latest development from the ECB as a trigger for covered bonds to catch up. In my opinion this is a long-awaited correction."
It seems that the ECB is now playing a vital role in putting the pieces back together. Covered bonds saw an immediate expansion of the investor base following its announcement, said Mauricio Noe, global head of covered bonds at RBS. "In addition to central banks buying again, we are also seeing more credit buyers and new investors beyond France and Germany to the likes of the UK and the Nordic region," he said, something that has been absent in this market for some time. "In a short period of time covered bonds have really felt the benefit. Investors are attracted by the endorsement of the product by the ECB as well as the effective backstop it places on the secondary market, capping any potential mark to market losses if conditions deteriorate as many are predicting."
One of the rationales for the ECB choosing covered bonds, aside from their importance in the broader European market according to Noe was that there had been the biggest drop off in liquidity of any asset class from the start of the crisis and this was of concern to the ECB. "Clearly any improvement to the provision of liquidity in this market, which was improving anyway, is hugely supportive to investing in the product."