Strength in adversity
The relationship between the covered bond and senior unsecured markets has evolved as the financial crisis has unfolded. Currently, the funding cost advantage of covered bonds over senior unsecured is by and large in favour of covered bonds, but that has not always been the case. Hardeep Dhillon reports.
The covered bond market and the senior unsecured market usually display quite a strong correlation during favourable market conditions. Better issuers have questioned the validity of maintaining a covered bond programme because the costs do not justify the spread disadvantage, said Ralf Welge, head of financial institutions origination at Commerzbank.
During a downturn, however, issuers are often more content to have a covered bond programme in place, due to potential difficulties in raising money in the capital markets. Weaker credits are especially likely to find this alternative option advantageous.
“Currently the covered bond market is much more interlinked with the government market than in the middle of the crisis, when there was a closer correlation between the senior and covered bonds,” said Welge. “This is because the covered bond market has taken on more risk – the country risk where the issuer is located, the bank risk and the cover pool assets.”
Some covered bond spreads are extremely close to senior unsecured. Others are vastly different. The discrepancy cannot be explained by the quality of the covered bond law, said Richard Kemmish, head of covered bond origination at Credit Suisse. The spreads between the two products are extremely tight in Italy, for example, where the covered bond law is one of the most robust and the underlying assets are one of the strongest in Europe. “That to me suggests that there should be a greater differential between the two,” he said.
On average, banks pay 104bp for a covered bond while the senior unsecured debt for a single-A bank stood at 145bp, according to Markit iBoxx index levels at the end of May. The funding advantage of senior bonds over covered debt mostly depends on issuer, on market, legislation and quality of collateral. “A general rule of thumb is the lower the issuer quality, the higher the funding advantage and absolute value for a covered bond in the market and this could be 30%-50% of the price paid for senior debt,” said Heiko Langer, senior covered bond analyst at BNP Paribas.
Any widening of the covered bond to senior unsecured basis is related to underlying market volatility and consequent impact on investor risk appetite, said Mark Geller, head of financial institutions syndicate at Barclays Capital. “As market uncertainty fades in due course, we will naturally see greater demand for unsecured debt from a wide variety of credits and in turn you will likely see a compression between covered and senior unsecured spreads across most jurisdictions.”
There has been more issuance of covered bond than senior unsecured debt: €78.6bn and €42bn of primary market activity respectively in the first four months of 2010. If issuers are in a position to launch a covered bond, they will prefer this funding route to senior debt, being predominantly the cheaper option, said Franz Rudolf, head of financials credit research at UniCredit. If this option is unavailable it depends whether institutions can issue anything into the public market, or whether they must rely on public support and the government guarantee programmes that are still in place in the periphery countries of Ireland, Greece and Spain (for more on peripheral countries, see separate article).
Many of the lower rated and distressed banks do not even have that access to senior or covered bond funding, making it not simply a question of price but one of market access. “The government guaranteed route will be the weapon of choice for the many institutions, who will try to fund as close as possible to governments and inside covered bonds, but this will come at a cost with additional strings being attached to such support,” said Mauricio Noe, head of head of senior and covered bonds at Deutsche Bank.
Both senior and covered bonds are important funding instruments though covered bonds offer the ability to lengthen maturity profiles, a cheaper funding source and a broader access to more issuers. National champions could possibly open the senior market but would have to pay a high spread and new issuance will be dependent on stabilisation of the sovereign market, said Ralf Grossmann, head of covered bond origination at SG CIB.
“Putting things into perspective, it would be easier for an issuer from the periphery to open the covered bond market and generally speaking the core countries would be in a position to open the senior or covered bond sectors,” he said.