Covered bond blues

IFR Pfandbriefe Covered Bonds 2008
5 min read

The implementation of a covered bond law in the UK in March has set the scene for the market to flourish. But without a fundamental change in investors’ perception of the underlying UK mortgage market, issuers are reluctant to test the waters yet. Han-Nee Tay reports.

The implementation of a law to govern UK covered bonds can only be a good thing for the market. Investors have been battered by worries regarding a range of financial instruments, most of which are less transparent and more complex than covered bonds. This law provides them with some level of comfort in a stressed environment.

For issuers, it offers another fundraising tool and, possibly, a wider investor base. Specifically, the new law brings UK covered bonds in line with the directive for the undertakings for collective investments in transferable securities (UCITS). It allows UCITS funds to buy more covered bonds from the UK, with an investment limit for regulated covered bonds set at 25%, compared to just 5% before. For insurers, the limit goes up to 40% – also from 5% previously. The risk weighting associated with UCITS-compliant covered bonds has been reduced to 10% from 20%.

Bankers are optimistic the favourable conditions brought by the new legislation could inspire issuers and investors to come to market. Since the credit crisis blew up, investors have tended to see UK deals in the same light as Spanish and Portuguese ones. Spain’s Banco Sabadell reopened the local market by selling €1.5bn (US$2.4bn) worth of covered bonds in early May, even pricing within initial guidance at 53bp over mid-swaps. Since then, several other Spanish deals had also sold. Given the positive reception recent Spanish deals have been met with, bankers said the UK could see an offering of its own soon. Some have suggested the UK market could absorb a £2bn (US$3.9bn) jumbo.

“Investors of the recent Spanish deals are the same ones who would have bought covered bonds before the crisis, which is incredibly encouraging,” said Mauricio Noe, head of covered bonds at ABN AMRO. “It shows that investors’ love affair with covered bonds hasn’t diminished. The spreads they are demanding are a fair bit wider but the fact is that the investor base remains solvent and still likes the product.”

The fact that UK issuers are not rushing to the market could also indicate that worries about mortgage banks’ liquidity are unfounded. Bradford & Bingley, which already has a covered bond programme, has said it still has £2bn of undrawn secured facility, and is in no hurry to tap the market in current conditions. Its head of funding and capital markets, Mark Winter, added that while the legislation was positive, it made little difference to Bradford & Bingley for now.

“Covered bonds under the new legislation may be seen as a safer buy by some investors because the bonds are underpinned by legislation but I’m not sure it’s going to have a significant impact for us because of our diversified investor base,” said Winter. “It may add a few accounts but I don’t think that is going to be material.”

The fact that the UK housing and mortgage markets are facing their worst period in years is certainly not helping issuers. The value of houses fell again in May, and the mortgage market has also contracted as buyers stayed away. “The general concern which affects issuers such as those in the UK continues to be uncertainty over macro-level mortgage risk, not the (covered bond) programmes themselves,” said Rob Robinson of the covered bond syndicate at Merrill Lynch and former chairman of the UK covered bond standing group committee.

Participants said regulators want to be able to react to the market in a dynamic way. As such, the legislation does not lay out a specific framework for issuers – as is the case in the German Pfandbrief market – but rather relies on a principles-based approach which allows regulators to assess cases on an individual basis. For example, it does not specify a minimum over-collateralisation limit.

“The FSA is actually expecting to be able to address what is required on a case-by-case basis,” said Angela Clist, a partner at Allen and Overy who was involved in the drafting of the legislation. “It enables the FSA and issuers to work at the level that is relevant to the case.”

Since the first structured covered bond was issued by HBOS in 2003, six other issuers have come to the market. All seven issuers have registered with the FSA and their existing programmes will come under the new legislation.