(To view the digital version of this report, please click here.)
For a brief moment the poster boy of bonds and the great hope for European bank funding, covered bonds have since slipped out of the limelight as the European debt crisis continues to tighten its grip.
“There has been an 80% drop in terms of volumes,” said Armin Peter, head of covered bonds at UBS in London. The figures make for stark reading. Issuance into the European covered bond market is low. Year-to-date issuance within the eurozone is a paltry €59.3bn according to UBS. The only year in recent memory with lower issuance was 2009 with €40.7bn.
As with manufacturing, Germany used to be the engine of covered bond issuance, but the volume of public sector Pfandbrief issuance in Germany this year makes for sober reading. Only €2bn has been sold so far this year. That represents 4% of the total supply, according to RBS. To put that figure into perspective, public sector Pfandbriefe represented 80% of supply in 2000.
“The Pfandbrief market has shrunk predominantly because the public sector has shrunk,” says Mauricio Noe, head of covered bond origination at Deutsche Bank.
So if public sector issuance has dropped off a cliff, are German investors simply looking at mortgage-backed covered bonds? Not really. Although there is clear demand from domestic investors, the issuance has not kept pace. What issuance there has been were sporadic and plain vanilla.
In early March ING DiBa, the direct and retail banking arm of ING Groep in Austria and Germany, sold a €500m seven-year mortgage-backed Pfandbrief that priced at mid-swaps plus 17bp; in late March mortgage lender WL Bank priced a €500m no-grow 10-year at mid-swaps plus 26bp; at the very end of the month German bank HSH Nordbank sold a no-grow €500m five-year mortgage Pfandbrief; and in late April regional bank Helaba sold an €1bn seven-year at mid-swaps plus 15bp.
Aside from the tight pricing, the size of the books in each of the cases stands out. Although they were only €500m deals, HSH Nordbank attracted orders of €1.2bn, WL Bank attracted €1.8bn of orders and ING DiBa attracted a whopping €2.6bn book – and that despite the tightening of guidance in all three cases.
Limited issuance and oversubscriptions can prove challenging for investors. “You are hunting for a premium in new issue, but when there is so little issuance, you can’t always see it,” says Torsten Strohrmann, portfolio manager, euro fixed income, at DWS Investment in Frankfurt. He has been looking at spreads at the short end in the secondary market.
Two issues have hampered domestic covered bond issuance. First and foremost tighter regulation and harsher treatment at the hands of the ratings agencies especially for public sector covered bonds is encouraging lenders to shrink and simplify their balance sheets. In its covered bond outlook for 2012, Fitch warned issuers to manage overcollateralisation levels to support ratings. “If an issuer fails to manage its programme’s overcollateralisation level, a more severe covered bond downgrade will occur,” it wrote.
This has had an effect and banks are considerably more cautious than they used to be. Towards the end of April, mortgage bank Berlin-Hannoversche Hypothekenbank announced a buyback of four public sector Pfandbrief issues, to give an overcollateralisation boost to its mortgage Pfandbriefe.
And it is noticeable that Deutsche Bank – the country’s largest bank and the canary down the mine for covered bonds – has only sold one issue this year – a €500m seven-year mortgage Pfandbrief at mid-swaps plus. Although €1bn had been expected, to avoid even the faintest whiff of too much granularity on the liability side, Germany’s largest bank capped issuance at €500m.
But the elephant in the room is €1trn liquidity the European Central Bank has injected into the market.
“The existence of LTRO means that issuers are suffering less funding pressure,” says Florian Hillenbrand, a covered bond strategist at UniCredit in Munich. One syndicate official estimates that thanks to the February LTRO, German banks have already met the majority of their funding requirements for 2012.
“We are looking at Scandinavia. “It is the lack of risk and close to the quality of German pools”
So the question remains where should or even can German investors look. The natural home for their money has always been France. AXA Bank Europe, for example, sold an €1bn five-year Obligations Foncieres backed by Belgian mortgages just before Easter at mid-swaps plus 70bp and German and Austrian investors got their hands on a quarter of the paper.
But as Tim Skeet, managing director in debt capital markets EMEA at RBS, said: “France will not come back until after the French elections.” While no major market impacts are expected from either the presidential or parliamentary elections, analysts are conscious of the effects of posturing in the run-up to parliamentary elections in mid-June.
Ahead of the French presidential elections, French assets widened in all asset classes across the board. Government bonds were up 15bp versus Bunds and covered bonds have gapped by as much as 25bp since the middle of March. They are likely to remain out there.
Ralf Grossmann, head of covered bonds at Societe Generale said: “The market reaction on the first round of the presidential election was clearly overdone, but political uncertainty is unlikely to be lifted until parliament is done and dusted.”
Hope on Scandinavia
Much in the same way that Scandinavian dramas are dominating television screens across Europe, the hope among German investors was that Scandinavian issuance would dominate the issuance landscape. “We are looking at Scandinavia,” said DWS’s Strohrmann. “It is the lack of risk and close to the quality of German pools.”
In mid-March, Norway’s Sparebank 1 Boligkreditt, the covered bond issuing entity of the Norwegian Sparebank Alliance, sold a US$1.5bn 5.25-year covered bond at mid-swaps plus 105bp. It was followed a couple of days afterwards by Sweden’s Stadshypotek, wholly owned by Svenska Handelsbanken, which sold an €1.5bn five-year at mid-swaps plus 30bp. It was the first Swedish covered bond in euros to hit the market in six months and by any standards a success. The book was €4bn and it priced 5bp inside initial guidance.
The latter was especially a hit with German investors, who took almost a third of the paper. More impressively, it traded in a couple of basis points in secondary to mid-swaps plus 28bp. Scandinavian enthusiasts were keen to point out that this meant that a new Swedish issue was trading through where one of the German Pfandbrief behemoths could expect to issue.
And at the very end of April, Finland’s Nordea Bank sold an €1.5bn seven-year at mid-swaps plus 40bp which followed its five-year €2.25bn at mid-swaps plus 65bp, the largest Nordic covered bond from the region, in January. The issue sold 5bp inside guidance and with no new issue premium.
It is understandable why German investors, indeed all investors, find Scandinavian issuance so attractive. “Investors look at Scandinavia for security not the yield pick-up. You can turn off the lights and go to sleep at night,” said UBS’s Peters.
But other syndicate officials are swift to temper investor enthusiasm pointing out that Scandinavian covered bond issuance particularly in euros has been driven by a favourable basis swap. The five-year euro/SKr basis swap tightened 21.5bp in the first quarter of 2012. It was 62.5bp at the beginning of the year and 41bp at the end of the first quarter. To expect a tidal wave of issuance is unrealistic.
Neither investor demand nor the rationale for covered bonds is going to go away. It is easy to see why, when investors see that WL Bank 22s are Triple A rated and trading 70bp over equivalent Bund spreads. But in reality German investors for covered bonds are going to have to hold their horses and wait – and hope – for a pick-up in the third quarter.