Austria last year became the latest country to take advantage of long-standing legislation to launch jumbo covered bonds. With an added dose of credit enhancement, its issuers were able to win favour with international investors. They are now working on ways in which legislation can be amended to make the Austrian instrument even more secure.
Like Germany, Austria has for over a century had its own Pfandbrief legislation. It might therefore have come as a surprise that when Kommunalkredit Austria launched the first internationally targeted jumbo covered bond from the country last September, it was not a Pfandbrief issue, but a fundierte Schuldverschreibung.
However, rather than being any new product, the fundierte Schuldverschreibung enjoys a long history, being the product of laws the first of which were written in 1874, when the imperial house of Hapsburg still reigned.
One of the main differences between the product and a Pfandbrief is that it can be issued by any bank, whereas Pfandbriefe must be issued by a specialised mortgage institution. This explains why the two names that have launched Austrian covered bonds to date - Bank für Arbeit und Wirtschaft (Bawag) being the second after Kommunalkredit - were already familiar to many participants in the international bond markets.
The established covered bond legislation and reputations of the issuers have not, however, meant that the product's proponents have been content to rest on their laurels. Indeed in the increasingly competitive international covered bond market the two banks understood that they would have to enhance the quality of their instruments.
Firstly, Kommunalkredit and Bawag have restricted the collateral eligible as cover for their bonds to the debt of, or guaranteed by, Austrian public sector entities and cash. Secondly, the two have subjected their cover pools to more stringent tests than those required by law.
Whereas the nominal value of the collateral pool is only required to be able to cover the value of the outstanding bonds, Kommunalkredit and Bawag must now calculate the value of their collateral pool based on market values, and have additionally introduced a 'safety cover value' to guard against spread widening, currency and interest rate risk as well as the cost of proceedings in the event of insolvency. The result is a more secure product with implicit over-collateralisation.
When Kommunalkredit approached the market ahead of the launch of its inaugural transaction in early September, it was clear that market participants were won over by the product.
Deutsche Bank, Morgan Stanley and SG were able to build a book of Eu1.6bn for the Eu1bn 10 year issue and, as a result, re-offer the paper at 8bp over mid-swaps, equivalent to 15bp over the July 2013 Bund. This was only a touch back from Depfa, delighting Franz Prantner, head of treasury at Kommunalkredit in Vienna.
"The difference between ourselves and Depfa is less than 1bp," he told EuroWeek, "which is great considering that this is our first transaction."
More testing for the product, however, would be the second transaction from the country. With a long term senior unsecured rating of Aa3 from Moody's, Kommunalkredit was able to achieve a rating of Aaa for its covered bond. Bawag, however, with its senior unsecured rating of A1 could only win an Aa1 rating from Moody's.
The reason for the three notch differential Moody's is willing to apply to the instrument is the lack of true bankruptcy-remoteness under Austrian legislation. In the event of an insolvency of an issuing bank, instead of being managed independently until maturity, Austrian covered bonds are repaid at par.
Some market participants were therefore sceptical when Bawag pitched price guidance for its debut Eu1bn 10 year deal in mid-February at 7bp-9bp over mid-swaps, the tight end of which was flat to the higher rated Kommunalkredit 10 year issue. But having built a book of almost Eu1.4bn, leads Barclays Capital, CDC IXIS and Deutsche could price the issue in the middle of the range, at 8bp over - just 1bp back from Kommunalkredit and again almost flat to Depfa.
A large part of the explanation as to why investors were willing to accept such pricing was, according to Reno Kroboth, head of new issues at the bank in Vienna, because of the quality of Bawag's collateral pool.
"There are two differences between Kommunalkredit Austria and Bawag issues," he says. "Because of the notching approach of Moody's, we have a lower rating. But we have 100% Republic of Austria risk in our cover pool, so we are offering investors the opportunity to invest in the Republic of Austria with a yield pick-up."
The performance of Austrian covered bonds is also likely to be reinforced by their rarity. Kroboth says that Bawag is only likely to issue one jumbo a year and Kommunalkredit's Prantner has similar expectations. After the launch of a Eu1bn medium term bond that BNP Paribas, Citigroup and Deutsche were preparing for Kommunalkredit as this report was being prepared, no further jumbos are therefore expected this year.
The market will continue to develop, however, albeit behind the scenes. Kroboth says that although on the issuance side only private placements are likely, the bank will be working on amendments to Austrian legislation that should hopefully allow Bawag - and potentially other issuers - to achieve higher ratings.
This is particularly important for Bawag since its A1 senior unsecured rating is on negative outlook. The main reason for this is the uncertain outlook for Bayerische Landesbank, which has a 46% stake in Bawag, and its relationship with the Austrian bank. BayernLB will, like other Landesbanks, lose the benefits of the German state support mechanisms from July 2005.
The key area of legislation that Bawag is hoping will be changed regards the lack of bankruptcy remoteness. "If the bank is insolvent, then currently the bond is immediately due," says Alexandra Primetzhofer, head of the funding desk at Bawag. "That is one of the main reasons why we do not receive a triple-A rating, but we are working on the law and we think that it can be changed either this year or next year. Investors will then benefit from higher ratings on our covered bonds."
Austrian law could also be changed to allow the inclusion of derivatives in the cover pool, as is permitted in several other European jurisdictions. This, says Primetzhofer, would ease the issuance of structured covered bond products for private placements.