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IFR Pfandbriefe Covered Bonds 2008
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With its innate ability to offer a relatively cheap cost of funding, more banks are now looking to establish a covered bond programme. However, with some covered bond markets essentially shut for the past six months, and 2008 supply predictions slashed accordingly, can covered bonds live up to the banks hopes and expectations? Rachelle Horn investigates.

There were 30 jumbo covered bond issuers in 2000, according to Heiko Langer, a research analyst at BNP Paribas. In 2008 that figure had risen to 86. Despite the challenging market conditions, the number of first-time issuers in covered bonds is still set to grow.

The appeal of the product for issuers is clear: in addition to being able to tap the market in large 'benchmark' size, the traditionally attractive cost of funding versus senior, unsecured debt has become all the more apparent since the onset of the volatilities.

A little over a year ago, the differential between a high Double A rated five-year senior, unsecured bond and a covered bond would typically have been around the 15bp mark. Recently this differential has been nearer 55bp–65bp for jurisdictions such as France. While such a move might pose something of a conundrum for the investor, for issuers, which are still unable to access the mortgage-backed securities market, the covered bond product is increasingly being viewed as the panacea to banks liquidity problems.

And nowhere is this more evident than with government policy makers. On both sides of the Atlantic, UK and US governments have outlined proposals to address the liquidity problems faced by banks through securitised and covered bonds.

But with the covered bond market closed for much of the first half – at least where the long end or more volatile jurisdictions were concerned – and the likes of Canada, Ireland, the UK and the US still absent form the public market, the amount of supply that will be issued remains highly dependent a number of factors, including the reintroduction of these jurisdictions.

Indeed, analysts who optimistically predicted another record year for issuance in 2008 have since slashed their forecasts. The changed landscape has resulted in a substantial backlog of mandated deals that are still to be priced.

In jumbo covered bonds, €32.293bn of supply (all currencies) was issued in the first quarter of 2008, a 45% decrease from the €58.826bn in the same period of 2007. Although not as stark, the downturn in all covered bond issuance has nevertheless been sizeable. In the first quarter of 2007, €67.21bn of covered bonds were issued; in the same period of 2008, the total declined by 39% to €40.765bn.

Covered bond analysts at Barclays Capital recently revised their 2008 gross covered bond supply forecast to €150bn from the €190bn originally predicted. Crucial to their decision was the continuing reluctance of the traditionally larger Spanish and UK issuers to tap the jumbo market, the former having abstained from doing so for the entire first four months of 2008. To put this in context, out of the €58bn of jumbo supply issued in the first quarter of 2007, €14bn was from Spain, while €8bn came from the UK.

One important determinant sustaining covered bond supply is investor sentiment. With inter-dealer trading volumes in covered bonds still practically non-existent, the primary market has effectively set its own level – the level at which buy-side accounts are willing to put their money to work.

Potential upcoming supply is still weighing particularly heavily on sentiments. The number of known and rumoured new issuers looking at the market is in excess of 20 (see table). In addition, a number of new jurisdictions are said to be looking at establishing a covered bond market, including those from emerging markets (see boxed item).

Although the pipeline is not as packed as it once was, there is still enough supply in the arsenal to provide a significant hurdle towards any spread recovery. The market is still in a soft environment, which in the approach to the summer could limit any potential performance, should there be a marked increase in supply. Issuers seem more and more willing to launch new debt at ever higher spread levels. As Michelle Bradley, a primary analyst at Morgan Stanley explains, CDS spreads have tightened considerably over the past month, but covered bonds have underperformed versus swaps. "We think the gap represents the supply risk," Bradley said.

On a positive note, the tone in covered bonds has improved significantly over the past six weeks, though from an issuers' perspective the impressive take-up for covered bonds has improved the appeal of covered bond funding. As IFR went to press, the market had not only seen the return of Spanish issuers and long-dated deals, but the month of May saw an impressive €20bn priced through 15 issues.

Indeed, As Tim Skeet, managing director and head of covered bonds at Merrill Lynch noted, some of the supply backlog is shifting.

"The market has shown in recent weeks that it does have a decent capacity to absorb supply – albeit at new pricing levels," said Skeet.

Finding new investors

Naturally, the ability of the market to absorb new supply lies solely with the buy-side. Interestingly, investors have begun to adjust their investment policies to the wider spread levels, which in some instances has been anything up to 60bp since mid-2007. Traditionally a combination of factors have provided the motivation for investors to put cash to work in the covered bond product, including credit quality, a degree of homogeneity, performance and liquidity. The groups of investors have typically included real-money investors, central banks, money market funds and bank treasury accounts.

Real-money investors are usually government bond benchmark based, and they invest in covered bonds because of the yield pick-up available. Central bankers meanwhile will follow a similar strategy, though they will tend to keep a closer eye on the degree of liquidity offered, which for covered bonds has decreased dramatically since the turmoil.

"The limiting factor to the market performance is the capacity of the investor base and the number of investors in the covered bond product," said Skeet. "Looking forward, the real challenge for covered bonds is how we can bring central-bank buyers back into the mortgage backed product and renew the non-European investor base buying."

However, the gentleman's agreement of not conducting inter-dealer market making since the onset of the turmoil remains in place, and as such overall liquidity remains extremely low.

On the other hand, banks, which typically favour the spread pick-up versus Libor and the repo-ability of the paper, appear to be showing considerably more interest in view of the higher issue premiums and yields. According to analysts at Dresdner Kleinwort, issues such as the recent short-dated Cedulas with returns well above the ECB refinancing rate promise an attractive carry for them.

"A big component of demand has always been financial institutions, and there are two notable observations concerning this demand," concluded Skeet. "Central banks have made repos significantly easier, which in the current context means that banks can have a highly liquid asset for banks to hold, and the fact that it is in Libor territory makes it all the more attractive. Also, the banks have been hoarding liquidity and they have to put this cash to work at some point, so the dynamics of liquidity may play into the favour of covered bonds."

Pipeline of debut covered bond issuers
JurisdicitonIssuer(Expected) RatingTypeLeads
CanadaCIBCAaa/AAADebut Canadian Covered BondABN/CIBC
CanadaBank of Nova ScotiaAaa/AAADebut Canadian Covered BondBarclays/BNPP/DB/Scotia
FranceBFBPAaa/AAADebut French Non-Law Based Covered BondNatixis
FranceCNCEAaa/AAADebut French Non-Law Based Covered BondBNPP/HSBC/Natixis
FranceCredit AgricoleAaa/AAADebut French Non-Law Based Covered BondTBD
FranceSocGenAaa/AAADebut Obligations FoncieresHSBC/SG/Uni
GermanyDapoAaa/AAADebut Mortgage PfandbriefBarclays/DZ/JPMorgan/LBBW
GreeceNational Bank of GreeceAaa/AAADebut Greek Covered BondTBD
GreecePiraeus BankAaa/AAADebut Greek Covered BondTBD
ItalyBanco Populare di MilanoAaa/AAADebut OBGHSBC/UBS
ItalyBanca CarigeAaa/AAADebut OBGNatixis/UBS
ItalyBanca OpiAaa/AAADebut OBGHSBC
ItalyIntesa Sanpaolo IMIAaa/AAADebut OBGTBD
ItalyMontepio GeralAaa/AAADebut OBGTBD
ItalyUniCreditAaa/AAADebut OBGTBD
NetherlandsNIBCNR/NR/AAADebut Dutch covered bondTBD
NetherlandsSNS BankAaa/AAADebut Dutch covered bondABN/Barc/DK
NorwayBN BolligkredittAaa/AAADebut Norwegian Covered BondBarclays/Danske/UBS
PortugalBanco BPIAaa/AAADebut Obrigacoes HipotecariasSG/Uni
SpainCaja CanariasAaaDebut Cedulas TerritorialasTBD
UKBarclaysAaa/AAADebut UK Covered BondTBD
Source: IFR