German investors are traditionally the biggest buyers of covered bonds in across Europe. They, like most others, had taken a huge step back from the asset class during the financial crisis. But their interest in a €1bn, five-year transaction, issued by Swedish bank SEB in late March, has opened the door again for Nordic covered bond issuers.
“Germans took around 70% of the SEB issue,” said Monika Rast, head of origination/international financial institutions at UniCredit Group in Munich. “They make up a large part of the original buyer base for covered bonds in general, so if they are showing interest again, this is one of the signs that the covered bond market is back on track.”
Issuers have been broadening their investor bases and lengthen their debt maturity profiles by pricing transactions in the euro-denominated covered bond market, and those in the Nordic region are likely to be no exception. Eurobond issuance possibilities could increase further still if the European Central Bank includes Nordic covered bonds in its plans for asset purchases, a decision that is yet to be made.
Whichever way that decision goes, the Nordic domestic covered bond markets have been the only ones to remain fully functional throughout the downturn. While the markets in Sweden, Norway and Denmark are each distinct, they continued to function because of the solid foundations upon which they are built: a strong banking system; an extremely supportive regulatory environment; high quality issuers; and, above all in the cases of Sweden and Denmark, a faithful and reliable investor base, ensuring liquidity. Issuers have therefore not had to look further than their home base for their funding needs.
These factors remain decisive, according to Ola Littorin, first vice president and head of long term funding at Nordea in Stockholm. They will continue to ensure the future performance of the region’s domestic covered bond markets, which remains far more important as a source of funding for issuers than the international capital markets.
“The domestic markets have a much longer history than the international benchmark market, which for us serves more as a complementary source of funding,” said Littorin. Covered bonds are the heart and soul of the Nordic financial system, particularly in Denmark (the region’s oldest market) and Sweden. Norway’s covered bond regulation came in 2007 and oversees a much smaller domestic market.
A number of important factors support covered bond ratings in the region, said Massimo Catizone, vice president and senior credit officer at Moody’s Investors Service in London: a rigorous underwriting criteria; a high degree of transparency; and a well-established, covered bond specific, legal framework. One important element of the latter is the Danish Balance Principle, compelling issuing banks to strike a nearly perfect match between assets and liabilities.
Yet no system is perfect. The Balance Principle in Denmark, for instance, means issuers often need to uphold a specific overcollateralisation level to maintain their covered bond ratings, Catizone said, forcing them to have more assets than liabilities on their balance sheets. It means banks can face difficulties maintaining their covered bonds target rating if they have to seek out assets: in theory asset quality deterioration, and weakening credit strength of an issuer could potentially drag the ratings of a covered bond down with them.
Because their cover pools are dynamic, the overcollateralisation in covered bond programmes is also dynamic, said Suzanne Albers, senior director at Fitch Ratings in London. If overcollateralisation levels increase, for example due to deteriorating credit quality within the pool or increased costs in liquidating the same assets, ratings pressure can arise. As yet Fitch Ratings hasn’t issued any downgrades due to weaker asset liquidity, but “we are reviewing certain rating criteria regarding the liquidity of assets,” Albers said.
Despite this, Nordic region remains one of the strongest in Europe for covered bonds and its regulatory regime is still much admired. A key challenge will be to supplement domestic investors with more interest from abroad.
“The international Eurobond benchmark market allows a slightly longer maturity compared to the Swedish market, as well as immediate access to larger funding volumes,” said Litttorin.
“The domestic markets work mainly as taps and issuance volumes are a lot lower,” agreed Rast. “In the euro-denominated market, apart from the diversification effect, an issuer can issue at least €1bn at one time.”
Thus far, the ECB’s decision to purchase €60bn of covered bonds from different entities in Europe has resulted in a general spread tightening, opening the door for a Nordic tap of the Eurobond market. If Nordic covered bonds are included in the ECB’s purchase program, conditions will be even better for issuers from the region.