The epithet "safe as houses" would make a good tagline for covered bonds as an investment at least in the eyes of the industrys stalwarts. Senior to unsecured debt (which will soon be bail-inable) and backed by assets which must adhere to rigorous standards enshrined in covered bond law, the asset class has been remarkably stable in recent crises compared to other forms of bank finance.
But the authorities have different ideas. Incoming capital requirements regulation for banks (Basel III) and for insurance companies (Solvency II) will require lenders and insurers to hold more capital against covered bonds they have bought that are rated below AA-.
Covered bond market participants say this could make some banks forced sellers, especially in a market where the triple-A rated covered bond has become a rarity.
Boudewijn Dierick, head of structured covered bonds at BNP Paribas and chairman of the Ratings Agency Approaches Working Group at the European Covered Bond Council, says regulators have failed to take into the account the far-reaching ramifications of a ratings cut-off in todays market.
"Even the difference between AA- and A+ has a huge impact because the charge becomes bigger and that can lead to forced selling, even though its just one notch," he says. "And at the moment, covered bonds are lower rated, amid lower rated sovereigns, and lower issuer ratings in general."
Out of covered bonds listed in the iBoxx euro covered index, 48% are now rated AA- and above, compared to 81% last July. Some of this decrease is down to redemptions, but a lot of it has come from downgrades. Spanish issuers in particular make up a large chunk of the iBoxx, and they have been hit again and again by the ratings agencies.
"Were moving towards a new environment where AAA and AA ratings are no longer dominant," says Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks, the vdp.
"You really have to search for these ratings these days. Yet at the same time I dont think we have any indication that liquidity in the product is dependent on the rating."
The heavy-handed approach taken by regulatory bodies has riled exponents of covered bonds, who argue that the product should be shown more respect because of the features that set it apart from other classes of debt.
Tolckmitt says that ratings are of minimal relevance when it comes to assessing the quality of covered bonds as an investment.
"Nobody can explain why they have done this, because the structural difference between a covered bond and a comparable bank or corporate bond is the same no matter what the rating is," he says.
"You have the double recourse, you have the legal basis, you have the special supervision in the end that is the benefit of the Pfandbrief asset class. You have a bigger safety net, and the reason you have that is because it is subject to the Pfandbrief Act, or the Cédulas Act in Spain, or the Obligations Foncières Act in France, and that has nothing to do with any kind of rating.
"Obviously cover pools look different from issuer to issuer but in the end the actual law is what makes a Pfandbrief a Pfandbrief it sets out the definition of the assets in the cover pool."
But with few other measures of quality available aside from ratings, what other strategies could regulators take to lessen the impact of a plain ratings cut-off?
Dierick says there is an alternative which could work within the current ratings system.
"You could have a step-down approach," he says. "That would mean that if your investment goes down one ratings notch, you are required to hold slightly more capital against it, then if you go down another, slightly more again. That would be more gradual, and would make more sense than having one single threshold.
"You could also conceive of an investment requirement connected to the label initiative. If the bond has the ECBCs label, it would be eligible, for instance. That might not work in practice now, but in the long run it could do. I dont know if there are many alternatives, and the system as it stands now seems unfair.
"Covered bonds have double recourse and there is implied support from the regulator because theres a law protecting it. The assets backing covered bonds have to fit certain requirements, and at least that way you know what the limits are."
Participants in the covered bond market have also long argued that their product should be treated as a Level 1 high quality asset within the Liquidity Coverage Ratio, a key component of Basel III regulations.
The LCR is intended to protect banks from short term market crises, by requiring them to hold enough high quality liquid assets to cover their cash outflows for 30 days.
Earlier this year, the Basel Committee threw banks a bone when it expanded the range of assets eligible for the buffer to include a broader range of corporate bonds, plus some unencumbered equities and certain residential mortgage-backed securities, as well as commercial paper.
The stock of assets is divided into two levels. The highest quality Level 1 assets must comprise at least 60% of the liquidity buffer and Level 2, up to 40%. The new proposals split Level 2 assets into two further categories.
Level 2A assets will have a minimum rating of double-A minus and are subject to a 15% haircut, while level 2B assets will be limited to 15% of the overall LCR portfolio and have a much higher haircut of 50%.
Covered bonds were conspicuous by their absence from Level 1 when the revised proposals came out.
But documents leaked by European policymakers in February, detailing parts of the fourth Capital Requirements Directive and the first Capital Requirements Regulation the legislation that, along with the European Banking Authoritys Technical Standards for hybrid debt, will enact Basel III that had been agreed upon, suggested that covered bonds would be eligible for Level 1.
According to the document: "Covered bonds traded on transparent markets with an ongoing turnover would be expected to be considered assets of extremely high liquidity and credit quality."
This stance is yet to be officially confirmed and ratified, but promoting covered bonds to this higher status would be a boon to the industry and would recognise inherent qualities that make the asset class of superior quality to other debt instruments, according to Tolckmitt.
"Liquid assets are assets that you can get liquidity for in cases of market disruption," he says. "One requirement for that liquidity should be that the value of the asset remains stable over time. Pfandbrief can really say it has been more stable than most of those assets eligible for Level 1, like government bonds, especially from certain jurisdictions within the eurozone. There is no argument not to admit Pfandbrief to Level 1."
Liquidity, but not as we know it
To appreciate the quality of covered bonds in terms of liquidity, one first needs to consider what liquidity actually means, he says.
The EBA is seeking feedback on its proposed methodology for determining what assets should be included in the high quality liquid assets buffer.
It is planning to use a scorecard system, measuring assets against the fundamental definitions of liquidity already included in the draft CRR, which include trading volume, outstanding amounts, bid-offer spreads and price stability.
Tolckmitt is confident that covered bonds will be deserving of Level 1 treatment, considering their performance over recent years.
"Track record, market depth, the market share of covered bonds relative to the whole economy all of these can be indicators for the liquidity of covered bonds over time," he says. "Pfandbrief has been proven to be stable, and that means that even in difficult times you can find investors who are willing to engage. You can use those criteria as a framework to differentiate between Level 1 and Level 2 in the LCR."
When it comes to liquidity, what really matters is finding a bid in a difficult market. And in a difficult market, there will always be one bidder, even after the others have run for the hills with varying haircuts, all covered bonds are eligible for repo with the European Central Bank.
That surely makes covered bonds perfect material for liquidity buffers. But the EBAs definitions of liquidity are not built around ECB repo eligibility, preferring instead to ignore the lender of last resort. Tolckmitt reckons it is time for this view to change.
"At the outset of the LCR, the regulators aim was to define liquidity without taking into account the ECB as the last resort," he says. "But after five years of crisis, can you really discount the ECB? Germany had liquidity without using the ECB too much, but some of the other countries did. Maybe it is time to look at wartime liquidity rather than peacetime liquidity, and considering ECB eligibility would be one way of doing that."
Allowing covered bonds as Level 1 assets would certainly help banks in countries such as Denmark where government debt is scarce, but it might not be of such importance for others.At the very least though, the draft proposals circulated at the start of February are a step in the right direction for covered bonds relationship with regulators, and may indicate a willingness to modify the AA- threshold. Until then, some covered bond investors will find their fingers hovering reluctantly above the sell button.