IFR Covered Bonds Report 2013

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.Spain has €238bn of Cedulas outstanding, excluding retained issuance, while Ireland has €21bn, and the spread performance of both has been impressive over the recent period. Irish covered bonds in particular have been in demand, with average spreads tightening nearly 400bp since January 2012. Cedulas spreads have come in around 200bp over the same period.To the casual observer the performance of peripheral covered bonds might seem surprising, given the adverse economic situation in those countries.Spain’s housing market in particular has been through an unprecedented bust so it might be expected that this would put pressure on securities largely backed by pools of mortgage loans. In fact, that has not been the case, largely down to the exceptional levels of protection written into the Spanish covered bonds legal framework.Supportive legislation“Spanish covered bond investors have a preferential claim on the whole non-securitised mortgage book, so the regulation is very supportive,” said Bernd Volk, head of covered bonds research at Deutsche Bank in Frankfurt. “There is a specific pool of eligible assets defining the maximum issuance but the extent of preferential claim is unique to the Spanish market.” Spanish banks do not provide sufficient granularity at loan level for meaningful analysis of loan quality, analysts say, but comfort is provided by the legal framework and by the expectation that Spanish covered bonds are likely to remain investment grade, even if the sovereign is cut to junk.Spanish rules dictate that the maximum amount of covered bonds that any bank can issue is 80% of qualifying assets, or in other words any bonds must be at least 25% overcollateralised. The great news for investors is that if a loan becomes non-performing it falls out of that calculation, so bondholders have double protection. The sole impact is that the amount of maximum outstanding bonds is reduced.For that reason, even as NPL levels at some Spanish multi-Cedulas banks are running at more than 11%, according to Deutsche Bank, covered bond spreads have outperformed sovereigns, particularly before the recent market sell-off. For instance, whereas German Pfandbrief spreads have remained more or less stable at around flat versus swaps this year, BBVA’s five-year covered bonds have tightened from around 250bp over mid-swaps to around 150bp over.Another key driver of performance in the covered bond markets across Europe has been a reduction in supply, which fell to €100bn last year, compared with €190bn in 2011, and this year is running at €43bn.In Spain, issuance was €10bn last year, and this year has reached €9bn from banks, including BBVA, Santander CaixaBank, Bankinter and Bank Sabadell. Redemptions over the whole year are set to be €39bn.Optimistic“The cheap funding from the ECB has curbed supply in covered bonds, in particular from the distressed countries, but we are seeing some encouraging signs that that market is starting to come back this year and there are redemptions which need to be refinanced”“The cheap funding from the ECB has curbed supply in covered bonds, in particular from the distressed countries, but we are seeing some encouraging signs that that market is starting to come back this year and there are redemptions which need to be refinanced,” said Ralf Grossmann, head of covered bonds at Societe Generale in Frankfurt.“Investors have more confidence that Spain will make it through the crisis and with yields so low elsewhere, the 150bp–200bp offered by Spanish issuers is a good deal.”Spain accounts for around 70% of European non-core covered issuance, and one indicator of rising confidence is the move in recent months to longer maturities. While the majority of issuance in the first quarter of last year was in the three to five-year bucket, the highest proportion in

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.A multi-year effort to build a framework for covered bonds in Morocco looks set to finally bear fruit this year, just when it is most necessary as mortgage lending growth has slowed. The African nation will follow in the footsteps of other emerging markets, such as Hungary, Slovakia, Chile and the Czech Republic, while hoping to avoid the failure in Romania. South Africa, the only other nation on the continent that could introduce covered bonds, ruled them out years ago when worrying about their seniority versus depositors.Morocco has been working on draft legislation since April 2011 when a technical committee made up of all the main market players – including the Central Bank, the Moroccan capital markets authority, major banks, and a securitisation company – was set up to fine tune the rules. Drawing heavily from German Pfandbrief laws the result was put out to public consultation until March this year.The Ministry of Economy and Finance expects the government and legislature to approve the final laws by the end of the year, allowing the first covered bonds to be issued in the second quarter next year. Credit Immobilier et Hotelier, the Moroccan bank with a 12% share of the country’s mortgage market, is chomping at the bit to be the first to issued a covered bond.Feeding growthThe fast pace of growth in mortgage lending in Morocco means lenders need additional funding routes. Total mortgage loans doubled to 26.2% of GDP in 2012 from 12.6% in 2006, according to MEF. In 2012, housing loans represented two-thirds of mortgage lending and 18% of GDP.Growth has slowed from the explosion in 2005–2008 where mortgages were up 35% each year on average to a more sustainable 6.1% in 2012, but funding pressure is building.Mortgage loans average 18 years and are largely financed by deposits, which are locked in – if at all – for short periods of up to six months. Also the ratio of customer loans to deposits surpassed 100% recently.The growing pool of domestic institutional investors – mostly insurance companies and pension funds – will also use the new class of long-term, high-quality private debt to reduce their term gaps. At the end of 2012, the country’s insurance companies had total assets of Dh154.9bn (US$18.16bn).“Morocco’s mortgage market has grown to such a size that asset liability issues have started to arise. Covered bonds are one way of solving this issue”“Morocco’s mortgage market has grown to such a size that asset liability issues have started to arise,” says Nouaman Al Aissami, chief of the credit division in MEF’s directorate of Treasury and external financing. “Covered bonds are one way of solving this issue.”“Morocco is one of few countries in Africa with a big enough mortgage book and large enough domestic investor base to consider introducing the bonds. A solid banking system and robust financial supervision are essential for them to function well. Their introduction forms part of the government’s goal to create a regional financial hub around Casablanca and to create the most dynamic capital markets in Africa,” Al Aissami said.In Morocco, the draft law has established two kinds of bonds: mortgage covered bonds and public covered bonds. Eligible assets for MCBs are primary mortgage loans with a loan to value ratio of less than 80% for residential loans and 60% for commercial loans.By September last year, total mortgage loans reached Dh218.6bn (US$25.7 billion), of which Dh147.5bn were home loans. It is estimated that around 40% of the housing loans qualify as cover assets, amounting to Dh60bn. MEF expects this sum to increase by about 10% annually.Eligible assets for PCBs are loans to local government that meet certain financial conditions and loans to public corporations guaranteed by the government. Currently, loans to local government add up to over Dh11b

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.Social security, as they say in Washington DC, is the third rail of American politics: full of voltage. Touch it, and you die.Much the same could be said, in the high priesthood of debt finance, about covered bonds. They are sacrosanct, inviolable, an apparently sacred asset class.In recent years investment banks, retail lenders, even whole countries, have fallen by the wayside. This year alone three European lenders (Co-operative Bank, SNS, and the venerable Italian outfit Banca Monte dei Paschi di Siena) and one tiny exposed eurozone state (Cyprus) have been restructured, nationalised or bailed in.In each case, senior or junior bondholders (or both) have taken a haircut on their investment. In the case of Britain’s Co-operative, owners of subordinated debt are likely to see some or all their assets converted into equity as the bank readies for a mooted London Stock Exchange flotation.Through it all, covered bonds have remained untouched and untouchable. However much regulators may have wanted to bail covered bonds into various restructurings – as the UK government is rumoured to have briefly considered during the collapse of Northern Rock – they have so far managed to resist the temptation.“The product is just too important for funding key areas of the economy and for financial stability,” said Ralf Grossman, head of covered bond origination at Societe Generale.Thus, despite all that has happened in recent years in Europe, home of the covered bond, the asset class remains impervious to the surrounding carnage.It is not the only bailout-resistant debt product on the market. Richard Kemmish, head of covered bonds at Credit Suisse, points to a few other restructuring-proof liabilities, including short-dated debt and trade creditors. But, to all intents and purposes, covered bonds remain bullet-proof and able to justify their high ratings (typically Triple A or just below).Even when the Co-operative was downgraded by Moody’s in late June, compelling the ratings agency to warn that holders of the bank’s subordinated and junior subordinated debt would recover as little as 35% of their original investment, there was barely a whisper about the lender’s remaining £600m of covered bonds, backed by an ample overflow pool of covered assets worth some £1.7bn. Simply put, you are more likely to see Satan skating to work than to witness the default of a tranche of covered bonds.Simply put, you are more likely to see Satan skating to work than to witness the default of a tranche of covered bonds.Privileged positionNor is there any outwardly visible sign that Europe, at the highest levels, is likely to tinker with this cosy state of affairs. The European Union’s Bank Recovery and Resolution Directive, set to come into effect as early as 2016, subjects unsecured liabilities to future bail-in requirements – yet exempts various secured debt obligations, notably covered bonds, from this treatment.“The current reading of the [BRRD] suggests that the secured claim of covered bonds will not be negatively affected by a bail-in regime,” said Christoph Anhamm, head of covered bonds origination at RBS.Credit Suisse’s Kemmish concurs. “All of the evidence so far tells us that covered bonds retain special privileges,” he said.There are reasons why Brussels, and individual governments, love an asset class tailor-made for the lean times. Covered bonds are heavily regulated, simple to structure and operate, and transparent, a port in the economic and financial storm that continues to rage across the continent. Moreover, said Kemmish, covered bonds actually work. “Issuers like them, investors like them, regulators like them: they have continued to work perfectly through the Triple A stress scenario of the last five years.”There are a few areas of concern. This being Europe, nothing is simple. The EU

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.Relative to its Nordic peers, Denmark has suffered an acute housing downturn, coupled with a number of bank failures. It is also renowned for having one of the toughest financial regulators in Europe, one that has been more aggressive than most in imposing losses on bondholders.Indeed, Denmark’s is an extremely idiosyncratic market, where individual home-owners are free to hedge their own mortgages. “The Danish have probably the most developed mortgage market in the world,” said Mauricio Noe, head of senior and covered bonds, EMEA at Deutsche Bank. “Banks need extra tools to allow them to hedge this optionality given to home-owners.”Others have tried to replicate what the Danes have built, but none have succeeded. Therefore, developments in the Danish mortgage or covered bonds markets may not therefore be applicable in other countries.Take junior covered bonds. These instruments have existed in Denmark since around 2005 on a private basis, said Ben Colice of RBC. “As rules and liquidity conditions evolve we will probably see a lot more of it,” he said.Would these make sense in other markets? Since the financial crisis, covered bonds have become very expensive, testament to the asset class’s performance at a time when many others have struggled. This has led some investors to look for cheaper alternatives – hence the interest in junior covered bonds, which offer many of the same features, but with a little more risk and return built in.“Junior covered bonds, ranked on a par with senior unsecured but benefiting from security on cover pools – [and therefore not subject to a] bail-in – and giving investors a bit of spread, could work,” said Boudewjin Dierick, in the financial Institutions solutions team at BNP Paribas. “It would need legislation in other countries, but most will want to see how things develop in Denmark before they commit to it.”However, some are concerned about the impact junior deals would have on the traditional covered bonds. “Some new investors would certainly like a new product, but it is important that nothing dilutes the existing brand,” said Colice. “It begs the question: what actually is a covered bond? Some labels have been proposed that could alienate potential issuers, such as Canadian and Australian banks, who are new to the asset class but have been embraced so far by investors. There is a natural tension between the desire to maintain the traditions of the product and respecting what investors want.”For this reason, and from a marketing perspective, some feel it is pertinent to avoid references to junior covered bonds at all. “We prefer to call them senior secured bonds, which better reflects the characteristics of the asset class,” said Monika Rast, head of origination, international financial institutions at UniCredit.The product evolved in Denmark to allow borrowers to maintain proper collateralisation in their cover pools amid falling house prices, or if needed to satisfy rating agencies’ requirements for higher overcollateralisation. “But other countries have found their own solutions to these problems”, said Rast.“The main thing is that senior secured bonds are a solution to fill a potential overcollateralisation-need in a cover pool,” she said. “They are not an instrument to fund new business and are therefore no funding alternative. The two products are not conflicting and therefore covered bond issuance volumes will not be influenced.”And with such tight spreads between senior unsecured and covered bonds, it may not be the most auspicious time to be launching products that find a home in the territory between these two existing products.Investment of last resort“During the height of the crisis covered bonds became somewhat volatile and illiquid, though to be fair that is true of all markets except Bunds and Treasuries,” said Noe.B

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.With traditional covered bond supply thin, Germany’s covered bond market is looking at new collateral types.The lack of supply in the covered bond markets this year has been particularly marked in Germany. According to Deutsche Bank, the total outstanding volume of Pfandbriefe hit €490bn at the end of March this year. This compares to just over €1trn of outstanding volume at the end of 1999.“There has been a net negative supply of covered bonds for some time,” said Mauricio Noe, head of covered bond origination at Deutsche Bank.With a lack of supply, spreads have been getting ever tighter. The average swap spread of the bonds included in the Barclays Germany Covered Bond Index came in from mid-swaps plus 15bp in mid-2012 to minus 1bp in May 2013. It has been a similar story with average spreads between mortgage and public sector Pfandbriefe. These have tightened from plus 4bp in mid-2012 to minus 1bp in May 2013.“We have reached a low on spreads. At the moment we have low yields and low spreads,” said Ralf Grossmann, head of covered bonds at Societe Generale. “In theory they could go below swap rates.”Grossmann mentioned the Muenchener Hypothekenbank €500m five-year deal in September last year, which is still spoken of with awe. The issue priced at mid-swaps minus 14bp via BayernLB, Credit Suisse, DZ Bank, Goldman Sachs and HSBC. As significantly, investors were not put off by the pricing.“Investors are primarily seeking safety and quality in today’s environment in the capital markets, which is why they value MuenchenerHyp’s conservative and low-risk business strategy”“Investors are primarily seeking safety and quality in today’s environment in the capital markets, which is why they value MuenchenerHyp’s conservative and low-risk business strategy,” said Louis Hagen, the spokesman for the bank’s board of management, at the time.And spreads have shown little sign of widening since then, especially as German Bund yields remain low. At the time of writing, the 10-year is trading at 1.54% while the five-year is at 0.56%. In February, real estate financing bank Berlin Hyp sold a €1bn 1.125% five-year covered bond. Led by Barclays, Credit Agricole, JP Morgan, Landesbank Berlin and UniCredit, the deal priced at mid-swaps minus 1bp. With a reoffer of 99.8650 it yielded 1.153%.Berlin Hyp has form in tight pricing. February’s deal followed another blockbuster last year. A €2.2bn book allowed Berlin Hyp to price a €1bn five-year at mid-swaps plus 9bp in May 2012. In secondary the paper even traded in a couple of basis points.This year’s trade was not another blowout, leading to complaints from bankers away from the deal about aggressively tight pricing and the inevitable mutterings about the size of the order book. But the deal does reflect the new pricing reality of covered bond issuance out of Germany. There is no sign that the current environment of tightening spreads and low yields is likely to change any time soon.Bodo Winkler, head of investor relations at Berlin Hyp, said it was not always helpful just to focus narrowly on the pricing, the more so as covered bonds from German issuers tend to price with regards to agencies or to where Laender, German states, have priced.“The discussion of whether a covered bond has priced Libor plus or minus is psychological,” he said.It is a point picked up by Torsten Elling, co-head of rates syndicate at Barclays in London, which led the deal. He said that the focus on Libor meant that “people are ignoring the absolute yields”. He compares the Berlin Hyp deal with the Deutsche Hypothekenbank covered bond that printed a couple of weeks previously in mid-January.Led by Commerzbank, Deka, Deutsche Bank, Natixis and Nord/LB, Deutsche Hypo’s five-year no-grow 0.25% €500m deal was initially marketed at flat to 2bp over mid-swaps. In the end it

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.Covered bonds backed by loans to small-sized and medium-sized enterprises are the product of two converging post-crisis trends, but in the last few months both of these have started to reverse.While regulators prefer covered bonds and banks have to use collateralised funding, SME covered bonds are a natural funding solution. Using SME collateral also provides banks with a reputational quick win – helping SMEs to fund has become as politically important as kissing babies.But regulators are starting to row back on their preference for covered bonds, as the European Commission works on a scheme to guarantee SME ABS, which holds out the prospect of capital relief – something SME covered bonds cannot deliver. Meanwhile, banks are well funded, with ready access to bountiful central bank liquidity.Using SME loans as collateral to bring down funding costs should certainly help banks that are prevented from lending to SMEs by skinny interest margins. Banks struggle with elevated post-crisis funding costs, while getting paid rock bottom rates on their floating rate assets.“Without the financial crisis, SME covered bonds wouldn’t exist. With it, they have to exist for the sake of the European economy”“Without the financial crisis, SME covered bonds wouldn’t exist,” said Richard Kemmish, head of covered bonds at Credit Suisse. “With it, they have to exist for the sake of the European economy.”They barely do exist – just one €500m deal from Commerzbank has been issued in Europe, complemented by several from Turkish institutions, often supported by multilateral development institutions. But more could be around the corner.“It’s not going to be a market of 100s of billions, but I’d say there’s maybe 10 or 15 issuers that could benefit from using this tool,” said David Kim, head of FI securitised products EMEA at Barclays.To see more issuance though, the asset class has to overcome some natural disadvantages. It is a maturity transformation which runs the wrong way – it allows banks to fund short-dated assets with long-dated funding.SME collateral itself, being lumpy, high risk and exceptionally diverse, gives a poor advance rate compared to mortgages or public sector collateral. Commerzbank gave its SME programme 21% over-collateralisation (11% mandatory). For its public sector sector programme, it only has 2% committed OC.Arguably, these factors make ABS a better format for banks to work their SME books. It is maturity matched, and banks can mitigate the low advance rates by selling the bottom of the capital structure.Kemmish says this view ignores a major strength of covered bonds.“An overlooked aspect of the ABS v covered bonds debate is that covered bonds are much better at handling constantly changing pools. SMEs are always amending terms, size, security and so on, so what you really want is a structure where they can be readily substituted in and out of a collateral pool.”“An overlooked aspect of the ABS v covered bonds debate is that covered bonds are much better at handling constantly changing pools”The existence of specific covered bond legislation, now present in every European country and gathering traction worldwide, is a signal to investors that covered bonds will be treated well in an insolvency, restructuring, nationalisation, resolution or any other conceivable scenario that a bank could find itself in. Most covered bond legal regimes presently exclude SME loans.Existing covered bond issuers are hostile to any attempt to blur the lines of what a covered bond is.The European Covered Bond Council, responding to an European Commission consultation on funding the real economy, said: “The ECBC … supports the development of this market segment as long as the fundamental differences between the two products – particularly in terms of recovery values between mortgage or  pub

To see the digital version of this report, please click here.To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.Peripheral banks were expected to forge a comeback to the debt capital markets this year, but apart from a few showcase covered and senior bond deals many treasurers seem unconvinced, saying spreads are too high and that cheap European Central Bank funding is just too good to turn down.“The issue now is that spread levels are still too high, and that we expect them to fall further,” said Isabel Almeida, director general, department of finance and markets at Banco Espirito Santo speaking to IFR in May, just after the Portuguese sovereign sold a €3bn 10-year syndicated bond.“The success of the sovereign is certainly encouraging, but does not come as a surprise to us considering the feedback we are getting from investors and the number of reverse inquiries we are receiving”“The success of the sovereign is certainly encouraging, but does not come as a surprise to us considering the feedback we are getting from investors and the number of reverse inquiries we are receiving.”As it stands, issuers like BES, Bank of Ireland, BBVA and Intesa can borrow from the ECB at 0.5%, but these banks regularly have to pay as much as six times that amount in a public bond deals despite an improvement in funding conditions for peripheral borrowers in large part due to the provision of cheap loans by the central bank.The ECB’s three-year LTROs, which ploughed some €1trn into the market, were aimed at warding off a liquidity crunch in the banking sector, but they were not supposed to be a perpetual crutch for Europe’s troubled lenders.Syndicate and DCM officials alike argue that, sooner or later, banks in the eurozone will have to stand on their own feet and seize funding opportunities when they are available.Indeed, the month of June served as a good reminder that windows are not permanently open, and that funding through the cycle remains most prudent.“Both issuers and investors will benefit if there is an ordered and steady stream of issuance, rather than feast and famine where levels need re-validating, liquidity dries up, and markets need frequent ‘re-opening’ transactions,” said a London-based FIG banker.Heading for coverCertainly some banks in peripheral countries are starting to make an effort to wean themselves off cheap ECB funding.Spain’s banks began paying back ECB funding earlier this year and have been making a concerted effort to reduce their funding through the ECB. The countries banks borrowed €259.3bn from the ECB in May, down from €265.1bn in April, marking the ninth consecutive month of falls.A retreat from ECB funding means that banks are likely to first turn to the relative safety of covered bonds.“In Spain we have seen Tier 2 and Tier 3 banks coming to the market so we think it’s only a matter of time before we start to see the national champions back again,” said Torsten Elling co-head of rates syndicate at Barclays in London.“A combination of low issuance volumes and high redemptions are going drive in spreads further, which means lower funding costs for European banks.”But in Ireland and Portugal the situation is not so rosy and ECB cash is proving all too attractive. Irish banks’ borrowing from the ECB and their own central bank inched up in June, which served as a reminder of the challenges still facing the sector.Ireland’s banks, at the root of the country’s financial crisis, are reliant on central bank loans to fund their day-to-day operations due to tens of billions of euros in deposit outflows and their exclusion from interbank lending markets.Despite this unfortunate situation, a number have been keen to show they have access to the covered bond market. Bank of Ireland, 15% state-owned and the only Irish bank to avoid wholesale nationalisation, was the country’s first bank to return to the public market, issuing a €1bn covered bond in November 2012 that was q