Northern appeal

IFR Covered Bonds Report 2012
11 min read

In times of stress investors flock to quality assets, and the greater the stress, the more migration takes place. In the midst of the greatest financial crisis in living memory, the covered bond market represents quality. And for an extra layer of comfort, the Nordic markets stand out as among the best in breed.

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With investors searching for sanctuary from the ravages of a turbulent global economy, few markets offer better shelter than covered bonds.

For those looking for an extra layer of protection, Nordic issuers offer the ultimate kite mark: “In this highly cautious market, many investors seek covered bonds issued by strong banks from countries with healthy balance sheets,” said Ted Lord, head of European covered bonds at Barclays. “In addition to covered bonds issued by Australian and German banks, many investors favour Nordic covered bonds.”

While confidence in the Nordic region has been somewhat undermined by the sovereign debt crisis, the impact has been mild compared with the rest of Europe. Nordic countries look healthy from a macroeconomic perspective: Norway runs a current account surplus, while Sweden breaks even. Bank ratings are under some pressure, but less so than in other countries. Nordic issuers have relatively low exposure to the euro crisis and problematic, Southern European sovereign bonds, compared with some of their continental peers.

Back on track

Even financial pariah Iceland can hold its head high in the covered bond space. The Icelandic financial crisis of 2008 enhanced the covered bond brand.

“In 2008 in Iceland, there was a total meltdown of the country’s financial system leading to the full-scale nationalisation of Iceland’s banks,” said Lord. “Outside Iceland, more than 500,000 retail depositors in Icelandic banks found their accounts frozen, which led to diplomatic disputes. Repayments on Icelandic bank debt were stopped – except on the outstanding covered bond issues of Glitnir and Kaupthing. Investors in these issues got their money back in full, on time, and with interest.”

“Iceland has a strong covered bond legislation. Given the developments elsewhere in the eurozone, some investors are showing interest in Icelandic covered bond issuance in the major currencies”

Now the asset class is one of the few bright spots in the troubled country. Arion Banki, the new financial institution which was established from the old Kaupthing, successfully placed ultra long-dated Icelandic covered bonds, with 30 years duration, to pension funds in the local market.

“Iceland has a strong covered bond legislation,” said Lord. “Given the developments elsewhere in the eurozone, some investors are showing interest in Icelandic covered bond issuance in the major currencies.”

Crucially, the Nordics experienced their own financial crisis in the 1990s from which they have learnt lessons other countries are only just learning. Nordic issuers are cautious and conservative, having been small players in the structured finance markets and having lent more moderately to home buyers. There are considerable differences between the Nordics: Sweden and Norway both maintain their own currency, while Finland, a euro area country, has no real alternative to euro issuance. Yet they are at least united by the perception of them as conservative, safe markets.

German enthusiasm

German investors have always been the key to the success or failure of covered bond deals. Germans are big believers in Pfandbriefe and the broader covered bond markets, and perhaps the biggest factor determining the success of the Nordic markets is the enthusiasm of German investors.

“The German Pfandbrief market is shrinking due to some German banks reducing their balance sheets in preparation for Basel III. New Pfandbrief regulations, such as keeping repayment amounts in cash or near cash for six months before payment, have also had an effect on limiting issuance of jumbo public Pfandbriefe,” said Lord.

This has forced German investors to look abroad for investment opportunities. Taking a top down view of the markets, the best substitute for Pfandbriefe, many have concluded, is the Nordic markets, which are the most comparable covered bond markets available from a sovereign credit risk perspective, said Monika Rast, head of origination international financial institutions at UniCredit.

“The Nordics have high quality collateral pools, low macro risk and a reliable funding approach, which makes them the first choice for many German investors,” said Rast. Half of all Nordic covered bond issuance denominated in euros ends up in the hands of German investors, she said.

Nordic covered bonds offer an attractive pick-up relative to the ultra tight spread levels seen in Pfandbriefe, reinforcing this incentive. And with there being little prospect of an increase in Pfandbriefe supply, the German interest is set to continue for the foreseeable future, Rast added.

Thriving domestic market

The euro market saw covered bond supply of around €63bn last year, with Nordic issuers accounting for €13bn of that total, a huge proportion relative to the significance of Nordic issuance in other asset classes. The biggest components of that total came from Norway and Finland, with €6bn and €5bn respectively, the larger markets of Sweden and Denmark seeing the bulk of their activity in their own currencies. So far 2012 has not been a typical year for Sweden in terms of covered bonds, the country typically issuing more euro-denominated covered bond benchmarks.

“The Nordics have high quality collateral pools, low macro risk and a reliable funding approach, which makes them the first choice for many German investors”

Norway also has a thriving domestic currency market. Following the collapse of Lehman Brothers in 2008 the Norwegian central bank established a swap programme, similar to that of the European Central Bank, exchanging Norwegian covered bonds for T-Bills. This focus on covered bonds created additional interest with Norwegian investors in the domestic krone covered bond market.

Additionally the regulatory environment incentivised some local investors to switch out of other asset classes into covered bonds, but this regulatory dynamic will not last forever, said Rast. Domestic institutional investor demand provides a good additional source of funding, but given its overall size it has some limitations. The strict investment guidelines of the Norwegian government pension fund, which is not allowed to invest into Norwegian assets, constitutes a further limitation.

Norwegian issuance is influenced by an institutional investor requirement that their allocations generate returns of 3.5%, encouraging long-dated issuance. However, the possibilities are restricted by the currency swap market, which only offers sufficient liquidity out to 10 years.

In Sweden and Denmark the domestic investor base is more developed, insulating issuers to some extent from the broader problems of the eurozone. Yet the Danish market is very different from the other Nordic markets: the country has suffered by association with a number of national bank failures.

“Some Danish banks have actually been downgraded partly because of their over-reliance on covered bonds,” said Mauricio Noe, head of senior and covered bonds, EMEA at Deutsche Bank. “However, a lower rating should not materially affect the very robust Danish market or cause Danish banks to adapt their funding strategy.” Danish issuers can rely on their domestic market for their krone issuance, with foreign issuers also interested in diversifying out of euros.

The Swedish market is also underpinned by the strength of the domestic demand for Swedish krona issuance. Swedish issuers in the domestic krone market tend to issue relatively small deals to establish a new benchmark and then tap small amounts on an almost daily basis, said Rast.

Unlike their peers in some other countries, Swedish banks, and to some extent their peers in Norway, can launch covered bonds that completely ignore international investors, with Swedish demand sufficient to satisfy issuer funding needs. A lack of yield on government paper ensures demand is always strong.

Loyal following

It is pertinent from a diversification perspective to spread issuance across a number of currencies, but this can be hard work: investors like predictable issuers that are present in the market at least once a year; issuers that visit markets sporadically are unlikely to have loyal investors in those currencies.

Swedish issuers have been good at maintaining a presence in the market, even if the price level from a cross-currency perspective did not always make a strong case for issuance. “They are not acting purely opportunistically, they have a commitment to the market that ensures investors in a range of currencies are willing to keep doing the credit work on them,” said Rast.

While investors do look at issuance in a range of currencies, most prefer to invest in their own currency, meaning issuance in different currencies broadens the investor base. Issuers must weigh up the costs and benefits of issuing in currencies outside the domestic market, considering, for example, cross currency fluctuations and how strong the demand from a given country is. A prolonged absence from a market can have an impact on the secondary curve and undermine future demand, meaning it can pay to issue even at unfavourable levels.

Outside of domestic currency markets and the euro, the only other significant issuance comes in US dollars, but even this market is relatively insignificant, with only a small handful of issuers – the biggest from the respective markets, including Nordea, DnB and Swedbank – active in the market. The US is a relative newcomer to the covered bond market, meaning demand is small compared to what is seen by euro investors.

The strong domestic investor bases in the Nordic countries also encourage foreign issuers into the Nordic market: all four of the large Australian banks, for example, having printed in Norway. At a time of so much uncertainty around the euro market, issuance in a mature market that does not run the euro certainly has some appeal. “Norway offered certainty in execution at a time when there was a distinctly negative feel to the market as a whole,” said Fergus Kiely at RBC.

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