The whale and the minnow’s shared challenges
Spain is one of the largest covered bond markets in Europe while Ireland is one of the smallest, but they face the same challenges – being overshadowed by central bank liquidity programmes, which may be set to keep spreads tight and issuance low for the foreseeable future.
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Spain has €238bn of Cedulas outstanding, excluding retained issuance, while Ireland has €21bn, and the spread performance of both has been impressive over the recent period. Irish covered bonds in particular have been in demand, with average spreads tightening nearly 400bp since January 2012. Cedulas spreads have come in around 200bp over the same period.
To the casual observer the performance of peripheral covered bonds might seem surprising, given the adverse economic situation in those countries.
Spain’s housing market in particular has been through an unprecedented bust so it might be expected that this would put pressure on securities largely backed by pools of mortgage loans. In fact, that has not been the case, largely down to the exceptional levels of protection written into the Spanish covered bonds legal framework.
“Spanish covered bond investors have a preferential claim on the whole non-securitised mortgage book, so the regulation is very supportive,” said Bernd Volk, head of covered bonds research at Deutsche Bank in Frankfurt. “There is a specific pool of eligible assets defining the maximum issuance but the extent of preferential claim is unique to the Spanish market.”
Spanish banks do not provide sufficient granularity at loan level for meaningful analysis of loan quality, analysts say, but comfort is provided by the legal framework and by the expectation that Spanish covered bonds are likely to remain investment grade, even if the sovereign is cut to junk.
Spanish rules dictate that the maximum amount of covered bonds that any bank can issue is 80% of qualifying assets, or in other words any bonds must be at least 25% overcollateralised. The great news for investors is that if a loan becomes non-performing it falls out of that calculation, so bondholders have double protection. The sole impact is that the amount of maximum outstanding bonds is reduced.
For that reason, even as NPL levels at some Spanish multi-Cedulas banks are running at more than 11%, according to Deutsche Bank, covered bond spreads have outperformed sovereigns, particularly before the recent market sell-off.
For instance, whereas German Pfandbrief spreads have remained more or less stable at around flat versus swaps this year, BBVA’s five-year covered bonds have tightened from around 250bp over mid-swaps to around 150bp over.
Another key driver of performance in the covered bond markets across Europe has been a reduction in supply, which fell to €100bn last year, compared with €190bn in 2011, and this year is running at €43bn.
In Spain, issuance was €10bn last year, and this year has reached €9bn from banks, including BBVA, Santander CaixaBank, Bankinter and Bank Sabadell. Redemptions over the whole year are set to be €39bn.
“The cheap funding from the ECB has curbed supply in covered bonds, in particular from the distressed countries, but we are seeing some encouraging signs that that market is starting to come back this year and there are redemptions which need to be refinanced”
“The cheap funding from the ECB has curbed supply in covered bonds, in particular from the distressed countries, but we are seeing some encouraging signs that that market is starting to come back this year and there are redemptions which need to be refinanced,” said Ralf Grossmann, head of covered bonds at Societe Generale in Frankfurt.
“Investors have more confidence that Spain will make it through the crisis and with yields so low elsewhere, the 150bp–200bp offered by Spanish issuers is a good deal.”
Spain accounts for around 70% of European non-core covered issuance, and one indicator of rising confidence is the move in recent months to longer maturities. While the majority of issuance in the first quarter of last year was in the three to five-year bucket, the highest proportion in the first quarter of 2013 was in the five to seven-year part of the curve. In addition there has been around €2.5bn of issuance longer than seven years, a maturity which was entirely absent in the same period last year.
“We believe there will be a steady flow of supply over the next year, as banks want to stay committed to the market, despite the cheap funding elsewhere,” said Grossmann. “We could see €15bn–€25bn of issuance [from Spain] next year.”
A driver of Spanish covered performance in the coming months is likely to be the European Central Bank’s financing operations. While the publicly placed Spanish market is €240bn in size, Deutsche Bank estimates there is an additional €150bn of bonds which have been retained for possible use as collateral with the central bank.
“The public market has contracted significantly because of redemptions and bond terminations after asset transfer to the Sareb bad bank since 2012,” said Deutsche’s Volk.
“With lending down and negative net supply, albeit that the negative supply is artificial, the technical situation regarding spreads of Cedulas versus Spanish sovereign bonds remains supportive. Falling sovereign bond prices are of course a burden for absolute Cedulas levels.”
One potential negative for Spanish covered bonds is the potential for house prices to fall more than the current 30% decline from their pre-crisis high. Goldman Sachs in a report in April said prices could fall another 10%.
“If we see a fallback in house prices, loan-to-value ratios tend to rise, which potentially leads to a reduction in eligible assets. House price change is probably the greatest uncertainty,” said Florian Hillenbrand, a senior covered bond analyst at UniCredit.
“In extreme cases, this could lead to issuers being forced to decrease outstanding volumes of covered bonds, but even that is not going to be a huge problem because ECB funding is available as a fallback option. That is why people are interested in collateral quality, but not worried about it.”
Another area of slight theoretical concern is the status of Cedulas in any bank bail-in. In the recent case of Dutch bank SNS Reaal, regulators exempted covered bonds from the expropriation which hit holders of subordinated debt.
The case nonetheless raised concerns and Spanish newspaper Expansion reported in April that the EU may consider forcing losses on covered bond investors in future bank rescues, as part of legislation to lift the burden from the taxpayer. In response Gunnar Hoekmark, the lawmaker leading work on bail-in measures in the European Parliament, said covered bonds would be exempted.
Nonetheless, some uncertainty remains. “In Germany, lawmakers have expressly excluded covered bonds from bail-in, and that proactive approach is the best possible solution for the market,” said Hillenbrand, “In most other countries there has been no mention of the issue, which itself means there is some level of uncertainty.”
As Spanish covered bonds markets have started to return to a healthier state, Ireland’s much smaller market has also been gaining momentum, backed up by a relatively low level of public outstandings, which run at around €14bn, according to Deutsche Bank.
“With such a small amount of publicly outstanding bonds, the market would in the worst-case scenario be relatively easy to wind down, easier than Spanish Cedulas for sure,” said Deutsche Bank’s Volk.
“While Irish banks have a lot of NPLs on their books, they have worked hard to keep their cover pools clean. NPLs in cover pools are typically less than 1% and don’t get credit in the cover pool matching calculation.”
With DEPFA out of the market, amid moves to sell the bank by state-rescued Hypo Real Estate, issuance is likely to remain muted, analysts said.
“From now the Irish market is likely to be based only on issuance from AIB and Bank of Ireland, and they will likely issue on a regular basis but in moderate volumes,” said SG’s Grossmann. “This year we have seen two deals with longer tenors than last year, so the message is that it’s about lengthening maturity profiles with underlying asset quality getting better.”
“This year we have seen two deals with longer tenors than last year, so the message is that it’s about lengthening maturity profiles with underlying asset quality getting better”
While Spanish Cedulas are trading inside the sovereign, Irish covered bond issuers offer yield pick-ups against the government bond of around 50bp.
As the broader economic picture in peripheral Europe improves, the banking sector in those countries has stabilised, However, with the financial crisis now in its sixth year, there are few who believe it is impossible that things could get worse.
That has become evident in recent weeks as covered bond spreads have started to widen. In addition, the correlation of both single and multi-issuer Cedulas with Spanish sovereign bonds remains very high, and has increased over the past two months from 0.84 in early April to 0.91 at the latest, according to RBS data. The beta factor has also increased – from 0.54 at the start of the year to 0.94 in recent trade.
“If we don’t see any moves towards a banking union following the German elections in September it’s entirely possible that we will see further downgrades at Spanish banks,” said Grossmann. “It could get worse for the banking industry before it gets better – and 2013 may be a turning point in that we begin to see whether the confidence the market has shown turns out to be justified.”