Insurers and asset managers are traditionally among the biggest real money investors in covered bonds, which provide a steady and secure stream of income and have an unblemished default record. Covered bonds are also more favourably treated than many others under Solvency II and Basel III regulations.
But despite this appeal, the yields on covered bonds will not meet the fixed rate liability obligations of insurers. The fall in covered bond yields has been driven by the flood of money provided by the European Central Bank in its two longer term refinancing operations.
In the first quarter of 2011, covered bond issuers, such as Canadian Imperial Bank of Commerce, Bank of New Zealand and Lloyds brought deals with coupons of 6% or more in the sterling and Aussie dollar markets. In euros, peripheral banks paid coupons of more than 4.75%, while issuers in core Europe were offering bonds with coupons of around 4.25%.
But in 2013 the situation has been very different. At 1.5%, French covered bond coupons have shrunk to less than half what they were two years ago and many Germany Pfandbriefe offer 1% or even less.
Covered bond investors have responded by going down the credit curve in search of yield. Where once they could be choosy and buy only triple-A rated deals, nowadays they cannot get enough of lower rated ones.
Covered bond deals this year from issuers such as Kuxtabank and Bankinter have been subscribed by as much as six or even seven times, while, many triple-A rated deals from core Europe have only just got over the finishing line, with books that have barely been subscribed, or only just oversubscribed.
“Investors are tempted to increase leverage, go down the credit curve, go into more complex products or buy ultra-long investments,” says Erik Rüttinger, head of credit at MEAG. “This will deliver yield, but the question is will they keep it by the end of the investment period?”
He cautions: “Investors should not make the same mistakes they did in the squeeze leading up to 2007.”
The classic response from covered bond investors looking for higher yields has been to turn to the rates or credit markets, says Rüttinger. But sovereign exposures have been shown to be anything but risk free, even though they attract no capital charge.
Though credit markets offer better potential diversification, they too have become squeezed and investors are often unable to get the yield enhancement they are seeking. Unsecured financials have also been sought, but they are liable to be bailed in under the Bank Recovery and Resolution Directive, while the capital charge for corporate bonds and unsecured financials under Solvency II is prohibitive.
Faced with these headwinds, covered bond investors have turned to ultra-long dated private placements. The long-term payment profile is attractive, but the investment is illiquid, many buyers have little understanding of how the money will be used and it is unlikely they will have a detailed understanding of the risk.
Though covered bond private placements will probably not default, they are illiquid and can pose mark to market risks. “Even if these bonds don’t default, it is likely that your risk and limit systems will force you to get out of these positions in a severe market stress phase,” says Rüttinger.
He suggests that project finance or infrastructure debt finance could offer viable alternatives but stresses the importance of undertaking technical, economic and legal due diligence, which can absorb considerable time and money. Such investments do not come without risks.
Investors must enter a bidding process with no certainty of an allocation. On the other hand, information and understanding of the project risk is likely to be much better than in a corporate bond. Though cashflow forecasts and recovery values are generally good, the investment is not liquid and there is no opportunity to hedge it with CDS.
Indirect exposure
Other traditional real money buyers of covered bonds are also looking at infrastructure investments, but taking their exposure indirectly.
“We are looking for infrastructure investments, but via funds,” says Manfred Skibowski, portfolio officer at Generali Investments in Germany. “If you invest through funds, you know the fees directly, so we prefer to mandate third parties.”
Skibowski also invests in long dated privately placed Schuldscheine, credit real estate loans and leasing loans via Generali’s Immobilien subsidiary, as well as emerging market and corporate bonds, which are all invested via third parties.
“The bulk of new investments are away from classic securities and financial markets, in non-rated assets, especially in infrastructure projects,” such as the Hamburg to Kiel autobahn, says Skibowski.
Banks like ABN Amro are also looking at new ways to develop partnerships with insurers like Generali, as Basel III regulations force them to recalibrate the higher cost of capital.
This is especially the case for funding projects where the time horizon is very long as, under Basel III rules, the capital charge for assets of an ultra-long duration is prohibitively expensive.
“What you see from Basel III is that short-term financing is OK but long-term financing is more and more of a topic,” says Danielle Boerendans, head of secured funding at ABN Amro. “We’re looking for more partnerships as we need to adjust our business model.”
The low yield environment and regulatory pressures are driving asset owners and investors to consider new ways of defining their business models, say bankers. Insurers are purchasing alternative loan portfolios directly from banks, with the assets typically being less liquid real estate, project finance, utilities or even SME loans.
“We have a lot of adaptation to do,” says a French banker. “We began working on the CRD two or three years ago and have increased infrastructure partnerships with a couple of dedicated funds.”
His firm systematically proposes new projects to funds when they fit, he says. “We own a big insurance company and create loan origination which we can sell on to it.” But sales are only possible where spreads are attractive enough to meet the insurance firm’s requirement.
The sale of some portfolios, such as those backed by residential loans, has not been possible because margins are too slim. “We need to be opportunistic,” says the French banker.
But the relationship between banks and insurers is apparently not that cosy. “A bank usually has more and better information quality due to its overall business relationship. There are also compliance issues as insurers would need to work more like a bank,” says Rüttinger. “It’s not a simple solution.”
The motivation for banks to consider such partnerships is also driven by an overarching need to reduce leverage. European banks have a long way to catch up, compared with their US peers, owing to the different structures of the two banking systems.
According to the European Central Bank, about 80% of credit intermediation in Europe is through banks, which is the complete opposite of the US, where about 80% of credit intermediation is via non-bank entities.
Direct partners
One way European banks can spur credit disintermediation, thereby lowering their leverage ratio, is through nurturing direct partnerships with insurers.
Another way is through selling securitisations. This is because ABS is the only market that offers issuers the ability to transfer risk. Issuers can manage their balance sheets more efficiently by removing capital consuming higher risk loans from them.
French issuers are already making preparations. “We’re working on an RMBS programme and all French banks are doing the same,” said the French banker, who noted that the launch date is about a year away.
“We’re also looking at selling the whole structure and totally consolidating the portfolio, which would address the leverage ratio, which is a concern for French banks.”
Hamstrung
But for the time being, some investors are hamstrung by regulations when it comes to ABS. “It is not a no-go to invest in ABS, it’s just that there is a high capital charge, which is the same as stocks under Solvency II,” says Skibowski.
ABN Amro’s Boerendans says an RMBS deal, in which the whole structure would have been sold, including all the junior notes, does not make sense for her bank.
“We looked at setting up a standalone programme like ING’s Orange Lion, but thought it was too expensive — there are different ways to manage leverage.”
Orange Lion 2013-10 RMBS was considered highly innovative as all the notes, including the capital consuming subordinated notes and equity, were placed with investors.
Apart from project finance and infrastructure investments, Rüttinger promulgates several other strategies, one of which includes buying ABS. He suggests allocating high quality assets like covered bonds at the long end of a liability structure and a basket of ABS, CLOs and CDOs at the short end.
Structured finance bonds at this point in the curve have high credit enhancement and are paying back. Also, because they are short dated, they avoid the high capital charge that afflicts the rest of the ABS market. And because they pay back around 30%-40% a year, it is possible to reinvest the returns if volatility spikes.
“If you are fully allocated to long term fixed rate bonds, you have nothing but pain in a market stress phase and no option to be a beneficiary of such a situation,” says Rüttinger. “ABS has excellent risk reward remuneration. The spreads may be lower, but you are more than compensated for the risks you take on the book.”
Other alternative investment strategies employed by Rüttinger include searching for new types of collateral such as SME covered bonds, using a CDS strategy by investing in iTraxx Main, or adopting an absolute return strategy in which short positions and interest rate options play a role.