Back to basics

IFR Pfandbriefe Covered Bonds 2008
9 min read

In a difficult 12 months for global financial markets, covered bonds have fared relatively well, attracting a range of new investors and issuers at a time when many other markets remain closed. But covered bonds have had to adjust to the new reality just like the other asset classes. Solomon Teague reports.

Global financial problems have ensured issuers have reined in their impulses to deliver increasingly innovative covered bonds in recent months. There is a prevailing mood of conservatism in the market. The credit crunch has frightened investors, driving them to become more risk averse and encouraging them to invest exclusively in securities they understand.

That investor sentiment must be seen in light of many experiencing what they had not previously envisaged, even as a worst case scenario: the collapse in value of Triple A structured credit investments and the sudden disappearance of liquidity in the structured markets.

Covered bonds are a relatively simple product – especially when compared to the structured credit instruments fashionable just a year ago – and that has drawn new investors to the sector.

"Although the covered bond market has not entirely escaped the problems affecting the credit markets over the past year, investors are aware of their flawless payment record since they were first introduced in 1769," said Ted Lord, head of covered bonds at Barclays Capital.

It is certainly true to say that the covered bond market was affected by the credit crunch. The market effectively shut down for two months in February and March, when issuance dropped to virtually nothing, and year-to-date issuance is now approximately 30% down on last year as a result. But in April, issuance picked right back up again, with as many issues as in the preceding two months combined, and that improvement of market conditions has continued through May.

The market is providing a particularly welcome alternative to issuers looking at different means of securing their funding, with some other markets closed and others ailing. Investors have been showing more interest in covered bonds – especially at the short end of the curve – as a period of underperformance relative to sovereigns has seen an increasing relative value trade between the two.

Some investors have been selling their sovereign exposure to lock in the appreciation they have already seen in the expectation of enjoying a pickup of up to 40bps on covered bonds with maturities this side of 2012. For longer dated bonds, the pickup falls off rapidly.

Certainly spreads have widened out dramatically over the last year. “Each new issue cycle is coming with slightly wider spreads,” said Heiko Langer, senior covered bond analyst at BNP Paribas in London. In the second half of May, Deutsche Postbank became another bank to price its covered bond weaker than expected, after guidance for the seven-year jumbo mortgage Pfandbriefe was set at mid-swaps plus 8bp area, with a coupon of 4.5%.

“The pricing isn’t ideal but at least the market is open,” said Karen Naylor, managing director in the structured finance ratings group at S&P in London.

Spreads being as wide as they currently are – at least partly a result of problems in the secondary market – is doing no harm to the appeal of covered bonds with new investors. Middle Eastern investors have joined the ranks of those showing some interest in recently launched products. Central banks have in increasing numbers added covered bonds to their benchmark indexes, said Lord. "The range of weighting can be anywhere from 10% to 26%, depending on the central bank investor, and this is a good sign for the asset class going forward."

The increasing expense in spread terms of issuance is no longer deterring new issuers from coming to market with inaugural deals, of which there have been a good number already in 2008. For example Banco Santander Totta, Portugal’s fourth-largest banking group, launched its inaugural €1bn three-year covered bond issue in mid May. The deal, which was led by BNP Paribas, Morgan Stanley, Santander and UniCredit, was rated Triple A at an indicated spread guidance of 40bp–42bp over mid-swaps, before being heard half sold within an hour.

Also in May, Bankinter's inaugural May 2010 Cedulas Hipotecarias was priced at mid-swaps plus 52bp by Barclays Capital, Natixis, Santander and UniCredit (HVB), equivalent to 123.3bp over the OBL 3.25% April 2010. It was also quickly sold, reaching €2.5bn on the day of announcement by the time of pricing early in the afternoon.

Covered bonds are attracting new interest all the time as issuers look to diversify their funding sources, the lessons of events like Northern Rock ringing in their ears.

“The asset class will emerge strengthened from the recent market problems because many banks have seen the competitive advantage secured funding offers in times of stress,” said Langer.

At the same time, investors have become more discerning about the covered bonds they are buying. Not only are they more fussy about quality of the asset pools underpinning the structures in which they invest, they are also becoming more discriminating about the country of issuance. The spread between traditional players in the covered bond space – particularly Germany and France – and the relative newcomers – Spain, the UK and Ireland – has grown. Those latter countries have seen much higher rates of volatility, resulting primarily from their not having such deep and sophisticated investor bases in the asset class to soak up issuance.

There has also been a growing tiering with countries based on the quality of a company’s business and prospects, regardless of size. "Investors are giving a clear signal that the quality of the business versus the size of the business of a covered bond issuer is increasingly important," said Lord. "This could lead to more tiering of spreads between covered bond issuers across all of the covered bond markets."

Similarly, the spread between covered bonds backed by public sector assets and those backed by mortgages is also growing, with the former gaining ground relative to the latter this year compared to last – another symptom of the investor flight to quality and the nervousness surrounding the housing sector.

The growing aversion to covered bond complexity is not stopping countries from paving the way for future innovation when investor appetite for such things returns. “The UK has been putting in place the means to include public-private-partnership loans, while Germany is also considering aircraft assets in the collateral pool, and Luxembourg, too, is intending to pass a law to allow the inclusion of rolling stock,” said Tanja Goudarzi-Pour, director of covered bonds structuring at SG in London.

Although investors are currently being conservative and shunning products with assets with a difficult credit story in the asset pools, issuers are displaying some innovative spirit in offering additional protection to investors, said Goudarzi-Pour.

For example, La Caixa priced a €1bn three-year public benchmark in April, using an extendable put option – a structure more familiar in the world of unsecured financial issuance – becoming the first issuer to bring a public puttable floating rate note in covered bonds.

The deal finally raised €1.6bn, lead by RBS (nee ABN AMRO), Calyon, La Caixa and UBS, and gave the investor the power to sell the paper back on a specified date, alleviating some of the concerns around the illiquid state of the Spanish covered bond market. The escalating Libor margin started at 5bp over mid-swaps for the first and second quarters, increasing steadily to 60bp for the 12th quarter. Such structures add a layer of cost for the issuers but help to ensure deals are done.

There remains a significant pipeline of outstanding deals waiting to be completed, and any return of innovative spirit in structuring products with exotic collateral pools will be unlikely until this is cleared, said Goudarzi-Pour.

“Europeans are still concerned about headline risk,” added Naylor. Understandably, many are concerned the same toxic assets that burned them in the securitisation market may end up in the collateral pools of covered bonds. Until this fear subsides there is little prospect of highly structured covered bonds returning to favour.