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Monday, 21 April 2014

Tiers after the hangover

Covered bond issuance from European banks is likely to remain low thanks to the eurozone crisis and harsher rules on overcollateralisation.

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Issuance of covered bonds from the eurozone is in decline. This year issuance from the eurozone is expected to hit a paltry €120bn according to figures from Barclays. Compare that with 2010, which saw a hefty €253.2bn gross issuance. What happened?

Tim Skeet, managing director in debt capital markets EMEA at RBS, elegantly pointed out that Europe has become a four-tiered market depending on strength of investor appetite, funding need and cost of market access for covered bond issuers. “Those who can, those who could, those who would and those who can’t.”

German and Scandinavian financial institutions fall into the first category; British and French into the second; Italian banks perhaps into the third; and Portuguese and Spanish banks into the final grouping.

The great divide

There is a stark gap between borrowing costs for German Pfandbriefe and the rest of Europe. In early June, Muenchener Hypothekenbank sold a €1bn 10-year 1.75% covered bond at mid-swaps plus 10bp or 63.4bp over Bunds. Compare that with Norwegian financial services group DNB Boligkreditt (like all Scandinavian issuers, given the dearth of German paper, the darling of covered bond investors) which in mid-June sold a €1.5bn seven-year covered bond at mid-swaps plus 40bp. And then look at Paris-based Caisse de Refinancement de l’Habitat which managed to sell a €750m tap of its 3.6% March 2024 covered bond at mid-swaps plus 103bp.

Europe has become a four-tiered market depending on strength of investor appetite, funding need and cost of market access for covered bond issuers. “Those who can, those who could, those who would and those who can’t”

At first sight the difficulty in European covered bond issuance looks like a straightforward hangover from the eurozone crisis. Although the country has also been distracted by elections, certainly that is why there has been little seen out of France so far this year. The only French deal since April was a SFr200m (US$205m) six-year from Credit Agricole in early July.

The French covered bond market has certainly been both thin and twitchy this year thanks to the Centrale du Credit Immobilier de France (3CIF) affair, which at the time of writing remains up in the air. In the middle of May Moody’s downgraded 3CIF from C/A3 to E/Caa1 and muttered darkly about the possible need for nationalisation. Some of its bonds, covered and senior, were suspended, but not before widening dramatically. CIF Euromortgage’s 3.25% February 2016s, for example, jumped 65bp on the bid before the suspension.

Even more than other issuers, French ones are known for their price sensitivity. “As soon as spreads look more attractive they are likely to come to the market. French issuers are very focused on how much they need to pay,” said Torsten Elling, co-head of rates syndicate at Barclays. Until then – like many of Europe’s banks – they will continue to take advantage of the European Central Bank’s €1trn cheap three-year funds that the ECB injected into the market.

Spanish pain

While it might be easy to explain away what investors have seen in the French market as characteristic of the eurozone problems, the issue is more complicated than that. A look at the Spanish market shows that Spanish banks have traditionally been heavy covered bond issuers.

There are €418bn of Cedulas outstanding, almost half of them redeeming in the next three years. There is little chance of them coming to market at least in the short term. Aside from the broader issue of deteriorating bank credit, deposit flight and an arthritic private placement market, even if Spain were able to sell covered bonds, it would be like putting a sticking plaster on a bullet wound.

But as Ralf Grossmann, head of covered bonds at Societe Generale, pointed out that explanation is not quite so simple. “Even if Spanish banks could issue covered bonds, the volume that they could sell would not replace the Cedulas that are redeeming. There would be negative net supply,” he said. Tighter regulation and harsher treatment at the hands of the ratings agencies especially for public sector covered bonds are encouraging lenders to shrink and simplify their balance sheets.

“Even if Spanish banks could issue covered bonds, the volume that they could sell would not replace the Cedulas that are redeeming. There would be negative net supply”

In its covered bond outlook for 2012, Fitch explicitly warned issuers to manage overcollateralisation levels to support ratings. “If an issuer fails to manage its programme’s over-collateralisation level, a more severe covered bond downgrade will occur,” it wrote.

Given the need to simplify their funding, European banks neither can nor need to issue as much as they used to.

That makes the outlook for European investors challenging as the massive oversubscription of any issues that do come to market makes clear. It has become a statement of faith to say that the US dollar market can help lighten the load. More than US$40bn of dollar-denominated covered bonds priced in 2011, up 36% from 2010, according to Thomson Reuters.

But aside from the fact that the US is starting from a low issuance base – the current size of US dollar market is only US$104.8bn – this year is already looking much thinner. There is likely to be only US$24.5bn supply in 2012. In short, the US dollar market is unlikely to pick up the strain in the short term.

There are two reasons for this. Although US banks would like to issue covered bonds, there is still no covered bond legislation in the US nor is there likely to be in the near future. Although the current US government is not opposed to it, there is now no longer time to get a bill through before the elections in November.

Canadian moves

Of more significance are recent moves from Canada. Much of the US dollar covered bond issuance has come from Canadian banks. Virtually all of them have required Canada Mortgage and Housing Corporation insurance. A shift in legislation in April removing what was a government guarantee, has been positive for the asset class. Although it has put the market on a firmer footing, it has increased borrowing costs for Canadian banks.

So what have investors been doing? For a start they have been looking at the secondary market. Even covered bonds from Ireland and Portugal are active in secondary thanks to a shifting investor base.

Banks and insurance companies have moved out in favour of hedge funds and high-yield funds. “The threshold yield for them is above 7% – that is when the hedge funds start to kick in,” said Torsten Strohrmann, portfolio manager, Euro Fixed Income, at DWS Investment in Frankfurt.

More risk conscious investors have been looking further afield. The rise of the Australian covered bond market since the end of last year has picked up some of the slack.

In April, Commonwealth Bank of Australia sold an €1.5bn 10-year covered bond. A standout transaction that saw pricing tighten in 8bp from guidance to mid-swaps plus 92bp, the deal was anchored by €1.5bn orders from French insurance companies as a 10-year OAT redeemed that day. But Australian issuance is unlikely to replace European issuance. Investors simply have to diversify their portfolios into corporates and government bonds.

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