Same game, different rules

IFR Pfandbriefe Covered Bonds 2008
10 min read

The collapse of established market making rules made a strong case for enhanced research capabilities among investors to adequately assess issuer and product quality across multiple jurisdictions. Though buyers’ focus is more on issuers right now, in the long term, it will shift to the quality of the collateral pool. Malini Menon reports.

The liquidity, value and diversification offered by covered bonds will always ensure investor interest. But, with the credit crisis stealthily taking away the first two attributes, they have had to rethink where covered bonds best fit in. With the credit crisis came a power shift; investors now call the shots and issuers must tick many boxes – to secure market access and foster long-term relationships with the investor community.

Covered bonds had been marketed as a liquid rates proxy by bankers and issuers in recent years, but many investors have now reclassified them. "In the last couple of months, covered bonds have become more of a credit product," said Thor Schultz Christensen, head of government and mortgage bonds at Danske Capital.

"Swap spreads to govies as well as covered swap spreads have widened,” added Christensen. “A strong legal or contractual set up has not been sufficient to maintain a stable spread. Today, covered bonds can be split into bank and collateral risk. The correlation between covered bonds and CDS spreads has increased."

Rob Dekker, portfolio manager at F&C Asset Management in Amsterdam, expressed a contrarian view: "There has been no change in the classification of covered bonds within F&C Asset Management,” he said. “Within F&C, covered bonds can only be part of the government bond portfolio. So, in that sense you can say that we classify covered bonds as a rates product – although there are of course some credit elements in the product.”

In general, the characteristics of covered bonds (the high quality, mostly Triple A rating and relatively lower spreads) match up better with government bonds and rates than with other credit securities, Dekker said. "Analysis of the specific names and issues in covered bonds is even more important for us after the credit crisis," he added.

The market making rules for covered bonds failed to provide the necessary liquidity in times of stress. As the credit crisis unfolded, official bid-offer spreads tripled, rendering the market making obligation for covered bonds inadequate. "Quotes on the screens were not tradable in a normal size. Trading was only possible if a market maker was axed to trade. So, covered bonds generally traded the same as other credits without market-making obligation. This made the price discovery and fair value assessment process difficult," said Dekker.

As prices of covered bonds now mainly reflect the differing quality of various issuers they have become the primary point of focus among investors, though there is an expectation the trend will fade in the long run. Ultimately the quality of the collateral pool should be viewed as the most important factor. Collateral pool transparency is therefore paramount, being vital to making an informed assessment of a specific security.

One way to deliver this could be promoting stronger working relationships among issuers, leading – hopefully – to better transparency for the investor.

"If the issuers provide optimal information to the investors, the less liquid markets are not such a big hurdle," said Danske's Christensen. "The challenge for the investor is that the supply pipeline looks strong. The RMBS market is not working in a satisfactory way and in relative terms, covered bonds are probably the best - and for some the only – solution."

Legal frameworks, cover pool characteristics, issuing entities, supply and demand factors and the state of the local housing market have all been cited as key factors in assessing a covered bond investment. However, “each deal must be considered individually; one can't generalise,” said Andrew Sutherland, head of credit at Standard Life Investments (SLI).

For instance, PIMCO analyses the covered bond market using a three-pronged approach. Initially, the country-specific legal environment is scrutinised. The analysis includes, but is not limited to, a thorough assessment of covered pool eligibility criteria, issuer default events and transparency requirements. With regard to structured covered bonds (for example, in the UK or the US), PIMCO confirms the issue's specific contractual features. An affirmative analysis is a precondition to investment in the structured covered bond segment.

Subsequently, issuer quality is measured in a process utilising PIMCO’s internal corporate research capabilities. The issuer’s brand name is assessed in the course of a corporate financial analysis, regardless of covered bond market type. A neutral to positive assessment advances the name to the next stage.

Finally, the covered bond segment is examined, primarily appraising the cover pool quality. Diversification of pool assets with respect to size and geographical distribution, as well as loan-to-value ratios, are essential tools used in measuring cover pool quality. In addition to the pool itself, PIMCO substantiates the issuer’s covered bond business strategy. A clearly focused and well-defined covered bond strategy is, from the PIMCO perspective, tantamount to success in the market.

Secondary dynamics

Following the credit crisis, the performance along the curve reflects the dynamics in the secondary market. The supply is coming at the front end of the curve, but the new issue discount means the secondary market is in the process of repricing, said Danske's Christensen.

According to asset managers, fair value in this repriced market depends on which market or asset the covered bonds are priced against, be it the govies, the swap or the credit or senior debt markets, or another. Compared to senior debt, investors find covered bonds cheaper.

"After more than six months of secondary market pain, securitisation markets are finally experiencing signs of relief, if not even a spread rally," said Danske's Christensen. Within the last few weeks the mood has finally switched to a positive direction – especially for high quality senior paper. "Covered bonds are still in pain due to supply risk,” he added. “With the latest development, we prefer covered bonds.”

Relative value can be identified not only between covered bonds and other fixed income segments, but also across the broadening spectrum of product types, frameworks and countries of the growing covered bond universe.

Compared to the first half of last year, current covered bond market liquidity is far more dependent on quality, maturity and the legal framework. According to PIMCO, numerous first-time issuers have been attracted to the covered bond market recently, and are willing to pay an initial issue premium – which can provide value. In general, PIMCO expects greater covered bond differentiation in 2008, based both upon the various bond types and distinctive national legislation.

By analysing underlying collateral and bank sponsor, and by comparing similar issues, fair value assessments can be made. "Credit generally is cheap; spreads are way out of line with long-term default expectations and it is just not limited to covered bonds," Sutherland said.

The Spanish, Irish and the UK markets have been the worst affected by the current turmoil. "Fear of the housing market bubble bursting and the liquidity situation with the UK banks resulted in a double hit for the covered bond market. A stabilisation of the housing market will take more than a year, so event risk will continue," said Christensen.

According to SLI's Sutherland, Spanish property is most at risk, followed by the Irish and then the UK. "Most overbuilding [is seen] in Spain; lots of Irish development as well but they stopped construction long before Spain. Also, Spain has possible illegal building problems," he said.

"The UK has the problem of weak consumers – but not over-building. There is a shortage of UK property, and people are not over-committed debt-wise as they were in the early 90s when we had the last big property crash,” said Sutherland. “However, for covered bonds, if the value of the collateral falls the sponsor bank has to put up more collateral. So, as long as the quality of the sponsor remains intact, property falls should not be a huge problem for covered bond holders."

Given the widening out of spreads as the credit crisis began to unfurl – as dramatic as up to 80bp in some cases – is it possible covered bonds could attract a different type of investor base? “Wider covered bonds spreads will probably not attract a different investor base currently, because spreads of all securities have widened significantly,” said Christensen. So on a relative basis covered bonds are not now more attractive then before the credit crisis – although there may be more interest from the rates side to increase their exposure to covered bonds, given higher spreads to government bonds.

It is difficult to say whether the rate-investor would unwind positions now that covered bonds are increasingly being classified as a credit product. Neither is it known yet to what extent credit investors – who previously bought corporates – will substitute these for covered bonds. One thing is clear: only when liquidity returns will we fully understand how different investors really feel about these different securities.