Before the beginning of last year the sterling covered bond market was the fixed income equivalent of obscure exotica, attracting little interest outside the activities of a few specialist collectors. In early 2011, all that changed, and the previously invisible market suddenly and unexpectedly became the height of fashion.
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Some £6.6bn of sterling-denominated covered bonds were issued last year, representing 25% of the total (with the majority of issuance still in euros) according to Barclays. The positive trend continued this year and year to date supply stands at £5.25bn, representing 14% of sales. That compares with 3% in 2010.
In seeking to explain the surge in sterling covered bond issuance analysts cite some circumstances that have helped the market slip the reins that held it back after HBOS sold the first UK covered bond in 2003.
“It’s both push and pull,” said Frank Will, head of covered bonds at RBS. ”On the issuer side the euro has been impacted by the eurozone sovereign crisis, and the cost of swapping back into sterling has increased substantially. At the same time the UK investor base has expanded, with covered bonds offering a yield pick-up to the rates space and regulators seeming to favour the asset class.”
UK sterling covered bonds offer a relatively high spread pick-up against Gilts with comparable maturities. In other covered bond jurisdictions the average spread over the sovereign is around 100bp, whereas sterling bonds pay 180bp–260bp over Gilts currently, according to Barclays.
In all but two UK programmes, covered bond collateral consists of highly homogeneous UK residential mortgages and small amounts of cash. The loan-to-value limit varies across programmes, but issuers can fund only up to 75% loan to value while levels of overcollateralisation on a nominal basis run from 140% (Abbey) to 187% (Barclays).
Concern over the fate of the euro, meanwhile, has seen issuance in that currency drop and euros accounted for 79% of securities sold this year (to May), according to Barclays, compared with 88% at the end of 2010.
The key players in the sterling space are Abbey National Treasury Services, which accounted for 35% of issuance last year and Lloyds TSB, which had a market share of 35%.This year RBS and Barclays have been conspicuous players, issuing £1bn each in January.
An additional boost has been that issuers have gone out of their way to make sure that recent deals have met investor needs, both in terms of format and maturity.
The Barclays and RBS transactions were longer-dated, with pay-offs scheduled for 2022 and 2024 respectively. These are exceptionally long durations for the covered bond market, but not so much for the sterling space where 45% of the deals last year had an initial term to maturity of more than 10 years, and the remaining 55% of supply had a term to maturity of seven to 10 years.
“Sterling deals have come at much longer maturities than their Continental European counterparts, and that’s because issuers are aiming them at insurance companies and pension funds looking to match longer-term liabilities,” said Jussi Harju, a strategist at Barclays. “For these investors it is a matter of getting a spread pick-up against Gilts and more favourable regulatory treatment compared with RMBS or senior unsecured debt.”
Another interesting recent development from an issuance perspective has been the emergence of publicly placed floating rate sterling-denominated covered bonds. Some £4.1bn of publicly placed floating rate covered bonds were issued by UK banks and building societies between January and March this year, according to Barclays, priced to offer an attractive alternative to senior RMBS notes sponsored by the same institutions.
Santander UK in January issued sterling-denominated senior RMBS notes from its Holmes master trust that paid a coupon of 175bp and 185bp over three-month Libor with weighted average lives of 2.8 and 4.9 years.
In the beginning of February, Abbey issued a three-year floating rate sterling-denominated covered bond with a coupon of 160bp over three-month Libor.
“We invest in both RMBS and covered bonds, so it is not a matter of either or in that respect, but covered bonds can offer a good alternative to senior debt, with the benefit of the collateral pool and less uncertainty of where in the capital structure you will ultimately sit” Ed Panek, Henderson Global Investors
“Given the stronger legal and regulatory support for covered bonds and recourse directly to the issuer, which is not available for RMBS, a give-up of 10bp or 15bp is pretty conservative,” said Barclays’ Harju.
Investors are also happy to buy covered bonds in place of senior unsecured notes.
“We invest in both RMBS and covered bonds, so it is not a matter of either or in that respect, but covered bonds can offer a good alternative to senior debt, with the benefit of the collateral pool and less uncertainty of where in the capital structure you will ultimately sit,” said Ed Panek, a portfolio manager at Henderson Global Investors.
Under European Commission draft rules on bank recovery and resolution published on June 6, national regulators may be given the power to write down senior debt of distressed banks or convert the bonds to equity. The rules are due to come into force by 2018, leaving only a short window for banks to issue new five-year senior unsecured bond that will not be impacted by the legislation.
The de facto subordination of senior debt rules plays directly into the hands of covered bonds, leading to the oft-quoted maxim that “covered bonds are the new senior”. Still, while investors may enjoy the greater protection over senior debt, they pay for the privilege.
Spreads on covered bonds trade anywhere from about 70bp (Barclays) to 180bp (Lloyds) tighter than their senior unsecured counterparts.
Moody’s and Fitch are among those that have expressed concern over the impact of senior subordination, and the issue has been at the centre of doubts expressed by the US Federal Deposit Insurance Corporation over prospects for a US covered bond market.
For some, the best response may be to impose limits on covered bond issuance, already in place in jurisdictions such as Australia and Canada. The UK does not currently have a formal limit, but the FSA reviews levels of asset encumbrance on a case-by-case basis.
Another key driver of investor interest in sterling covered bonds in the recent period has been the rolling off of government-guaranteed issuance printed in 2008 and 2009.
“A lot of funds were sitting on that Triple A rated product, but realise there won’t be a massive amount of government-guaranteed issuance going forward,” said Matthew Pass, head of bank debt at RBC Capital Markets. “With sovereign debt not looking attractive, asset managers and bank treasuries have bought into the covered format because of favourable spreads and low risk in terms of credit exposure.”
Still, while the sterling covered bond market has taken a great leap during the past 18 months, it is still in its relative infancy, and with a secondary market yet to make an appearance, liquidity remains an issue. Whereas the euro-denominated market trades on maximum ticket sizes of €50m, bankers say sterling deals are more likely to be found around the £5m mark, if at all.
“These certainly are not bonds that you would want to think about shorting, as you would never be able to find them,” said Henderson’s Panek. “On the whole, investors are pretty happy to put them away in a drawer and hold to maturity.” Buy and hold was particularly evident in the longer-dated space, Panek said.
In addition, partly because of the increased cost of currency swaps, the sterling market is not economic for non-UK issuers, who have yet to take part, and the investor base remains almost entirely UK based.
Furthermore, there are regulatory mismatches, with the UK’s framework put together on somewhat of an ad hoc basis since 2003. The UK was originally distinguished from its European counterparts by the government’s decision not to implement European UCITs regulations relating to covered bonds. Instead UK issuers sold bonds under general law.
Gradually that has changed, and in March 2008 the UK Regulated Covered Bonds Regulations came into force. Those were strengthened after a review last year, which recommended new measures, including stronger control over asset pools, compulsory reporting of loan level information and a strict 8% minimum for levels of overcollateralisation. The amended regulations will come into force on January 1 2013.
“With the new regulations the UK market has become one of the most comfortable from an investor point of view,” said Barclays’ Harju. “It’s early days but the future for sterling issuance is positive.”