Too strong for its own good?
The Pfandbrief market emerged from the crisis in good form, with appetite again strong and spreads compressing. But the depth of domestic demand combined with net negative supply could actually thwart plans to internationalise the asset class. Philip Wright reports.
While it was not immune from the turmoil caused by the global financial crisis, the Pfandbrief market emerged relatively unscathed compared with many other asset classes. Its strong fundamentals and committed investor base served so well that recent issuance has even crept back into the realms of single-digit spreads.
The market has developed strongly and strengthened its status as the quality leader, according to the Association of German Pfandbrief Banks (vdp), speaking at its annual press conference, held on April 14. In fact, the Pfandbrief market was one of the few real winners of the crisis, said Vdp president, Henning Rasche, highlighting its strong regulation, simple structure, on-balance sheet nature and transparency. It echoes the picture he painted towards the end of last year, when he said the Pfandbrief market was “the last to be hit by the financial crisis and the first to return to normal.”
But apart from the acknowledged robustness of the structure, there are other factors at play.
Germany has always provided the bedrock of demand for Pfandbrief. This appetite continues to support spreads at a level that are simply unattainable in other jurisdictions, though investors in other countries may be just as patriotic when it comes to buying decisions.
“Domestic markets often price domestic credits completely differently from the rest of the world – although this usually does feed through to the rest of the market eventually,” said Tim Skeet, head of covered bonds at Bank of America Merrill Lynch.
This underpins the sector many regard as the nation’s flagship, the perceived litmus test of the state of the wider German bond markets.
On the other side of the equation, supply – most notably in the jumbo arena – is waning, adding even more pressure to spreads. According to estimates from UniCredit, 2010 jumbo issuance volumes will reach €28bn, against some €69bn of redemptions. Working on an assumption of €13bn of mortgage-backed and €15bn of public sector new paper, against maturities of €17bn and €52bn, the bank’s rollover expectations are a relatively healthy 78% and just 29%, respectively.
As the vdp noted, Hypothekenpfandbrief volumes have recently outstripped those of Oeffentliche Pfandbriefe for the first time in 40 years, again leading to potential spread compression.
Helaba illustrated these issues when it sold a rare public sector transaction on the same day as the vdp’s press release, April 14. The €1bn seven-year priced at 8bp over mid-swaps and was placed 62% into Germany. The book reached €5.4bn and it was only a desire to internationalise allocation as much as possible that more of the paper – indeed, potentially all – was not placed with domestic accounts. The bonds tightened a couple of basis points as soon as they were freed to trade, taking them tighter than French government agency Cades and close to French government bonds themselves.
Helaba may be an exception (it is a rare issuer, has not been downgraded since the 2005 loss of state guarantees, is zero risk-weighted within the Landesbank and savings bank sectors and had 92% of German cover assets on this deal). But, given the return on offer, non-German investors decide better opportunities lie elsewhere to the same extent as domestic accounts extol its virtues.
The Helaba deal also underlined the credit tiering within the Pfandbrief market itself. By way of comparison, Deutsche Pfandbriefbank’s January issue – also a Triple A rated €1bn seven-year public sector transaction – came at plus 38bp.
“Just because something is called a Pfandbrief and therefore all is well, is no longer the complete story,” said Skeet. “The issuer is still a financial institution and the rating agencies are reminding us of this fact”.
This phenomenon is not confined to Pfandbriefe: investors in ABS deals, and even the government-guaranteed sector, are increasingly looking behind the headline details and differentiating between credits accordingly.
The needs of the key issuers of Oeffentliche Pfandbriefe no have also changed over time, said Skeet. “Much of the underlying eligible collateral has disappeared,” he said. “It was being driven by sovereign paper such as BTPs, or Landesbank paper, which is no longer eligible. In fact, much of what was once eligible and desirable is now neither of those things.”
Where does this leave issuance? Bernd Volk, head of European covered bond and agency research at Deutsche Bank, reckons the asset class will “continue to be an important funding tool for German banks but, given the significant decline in outstanding volume, this is likely to be at a lower level”.
While there are new entrants to the market, one German notable being Deutsche Bank itself, he does not see this as making up the shortfall. Ultimately, there are too many alternatives available to issuers. “Pfandbriefe will be a crucial part of the funding mix,” said Volk, “but probably not a dedicated business model.”
There may be some respite away from the jumbo arena. Registered Pfandbriefe now make up almost 40% of the market. The demand for such deals, predominantly from insurance companies and the like, on an essentially private placement basis, looks set to continue. Ironically, however, the prices available to issuers through this route could make the jumbo option look more expensive, potentially discouraging supply.
There is also now a greater acceptance of smaller deals. A small-ticket public transaction of €500m is more likely to be accepted than once it was. Aareal’s €500m five-year from January and COREALCREDIT’s €500m four-year launched towards the end of last year (both Hypothekenpfandbriefe) exemplified this, the latter not only because of its size but also because it was not Triple A rated; it was rated AA– by Fitch. This is when the domestic investor base comes into its own, with nearly 93% of those bonds placed within Germany.
In spite of the strong demand in its home market, there remains both a need and desire to internationalise the Pfandbrief. Presentations of various descriptions have been held in a number of jurisdictions by the vdp. Most notable of these is the US, which is seen by many – not just in Germany but in Europe as a whole – as providing the greatest depth of untapped demand. It is seen as potentially the biggest growth area for the covered bond product.
“The claim to be the gold standard, though compelling, could be somewhat hobbled by the lack of international supply and overall shrinking volumes,” said Skeet. German issuers are likely to look very closely at internationalisation, despite the crown for reopening the US market to Europeans (after a three-year hiatus) being ripped from their hands by a French borrower, Compagnie de Financement Foncier (CoFF) on April 15, with its US$2bn three-year Obligation Fonciere.
International aspirations aside, the relative lack of supply and strong domestic market look set to keep funding levels at low levels. “Despite some fundamental concerns, I can’t really see why they would go significantly wider,” said Volk. “Maybe, when the ECB buying stops, it might widen by a few basis points, but not 30bp or 40bp – short of some external shock.”
The ECB’s €60bn programme is scheduled to finish by the end of June this year at the latest.
Amendment underpins quality
The adoption of the draft of the second amendment to the July 2005 Pfandbrief Act further underpins the market. Taking place on March 24, almost exactly a year after the first amendment, the act is scheduled to come into force at the end of October.
“An important provision….strengthens the collateral manager’s position by making it possible to procure liquidity in the event of a Pfandbrief bank’s insolvency either by refinancing through the German Bundesbank or by issuing new Pfandbriefe,” wrote analysts at BayenLB.
The clarification of the status of the cover pool in the event of an issuer’s default is seen as key and the amendment means that the cover pool can now be considered a covered bond issuer (Pfandbriefbank) with limited scope of business.
“This is not just a semantic difference because, with status as a Pfandbriefbank, the German legislator wants to ensure the cover pool’s ability both to issue Pfandbriefe and to participate in repo transactions with the German central bank. This arrangement was not clear from the wording of the 2009 Pfandbrief Act,” said Moody’s.
While the BayernLB analysts question the appetite for new paper from an already insolvent bank, they view access to Bundesbank repo transactions as a positive and something that offers “a realistic possibility for filling short-term financing gaps”.
Moody’s views the change as “a significant improvement [that] would mitigate refinancing risks, which we believe are the key risks in covered bond transactions”, underlining the fact that an already strong structure is being strengthened further.