The financial crisis has been good for covered bonds. Though issuance fell from 2007 to 2008, it has grown since and this year it looks set to make up for lost time.
The phenomenal comeback has in no small part been due to a more conducive regulatory environment which, along with spread convergence to senior unsecured, has boosted structural demand. And with that, many countries have been anxious to develop their own covered bond laws, not least the US.
What is particularly impressive is that covered bonds have been able to provide liquidity, not just to the strong banks, but the market has also thrown a lifeline to many weaker credits — though not all.
"It has been one of the few products that got stable funding on competitive terms through the crisis, something that did not apply to all government bonds in the eurozone," says Jens Tolckmitt, chief executive of the VdP (Association of German Pfandbrief Banks). As a result, many local and even foreign issuers are planning to set up Pfandbriefe programmes, he says.
But some jurisdictions have struggled to access the market. This continues to be the case for Spanish cajas which look set to remain shut out until the Bank of Spain’s efforts to restructure the sector have been completed. Portuguese and Irish banks have also barely been able to access covered bonds or have been shut out.
But apart from these special cases, access to liquidity for the bulk of Europe’s banks has been sound. The figures speak for themselves: according to Dealogic, jumbo covered bond issuance stood at $122bn in 2008, a year that many say was the nadir of the crisis. A high number perhaps but still down by $84bn from the year before. In 2009 banks found $171bn of covered bond funding and last year that number rose to Eu233bn.
With almost $111bn issued in the first 10 weeks of 2011, the market’s growth looks set to break all precedents this year and far exceed the market’s consensus forecast of Eu200bn.
"Even after the ECB’s buying programme the market has held up incredibly well, we’re not even through the first quarter and issuance is almost halfway towards meeting most analysts’ predictions for the year," says Marco Bales, co-head of capital markets at UniCredit.
This year’s spurt in supply has also been matched by an ever-increasing number of new issuers. Last year as many as 18 new banks issued deals off newly set up programmes, adding nearly Eu30bn of supply, according to Barclays Capital covered bond strategist, Fritz Engelhard who points to a consistently improving trend over recent years. In 2009 new borrowers issued Eu24bn through more than 20 deals and in 2008 16 new borrowers issued Eu18.5bn.
German reliability
Counter-intuitively, the only sector not to have benefitted from this growth has been Germany’s Pfandbrief market, which is the most established of all and remains the bedrock of demand for nearly all borrowers in all jurisdictions. "The very strong and reliable domestic investor base has been a big contributory factor to the stability of the Pfandbrief market," says Tolckmitt.
In BayernLB’s case, about 60% of its issuance is typically placed locally, which is less than its German peers. This relatively high international investor participation, which includes some large Asian central banks, "shows that the global market trusts the German product," says Horst Bertram, head of investor relations at BayernLB. "German banks are aware how important the product is and they want to keep it clean."
Legal amendments in German Pfandbriefe have always been in investors’ favour. Last year, for example, a change in the law introduced a banking licence for administrators managing the pools of insolvent issuers as a basic requirement to access central bank liquidity and issue Pfandbriefe in their own right. "This will again make it easier for the administrator to access liquidity without having to resort to a fire sale, and without having to rely on other counterparties," says Tolckmitt.
But Bertram concedes that Germany has its share of problems. In his view the local market can be sub-divided into four: good credits with limited funding needs; good credits with higher funding needs; weaker credits with limited needs and weaker names with high funding needs.
"The first two groups were always able to issue at attractive terms," says Bertram who puts BayernLB alongside Münchener Hypo, for example.
Much can be deduced from the spreads German issuers must pay: Münchener Hypo, UniCredit (Germany), LBBW and BayernLB have all issued two to five year bonds at or tighter than mid-swaps plus 12bp this year. Dexia Kommunalbank, Eurohypo and Aareal on the other hand have paid between 25bp and 40bp.
But irrespective of this rainbow of German Pfandbrief credits, the market is technically well supported as redemptions exceed issuance. "There is a constant support for the German product," says Bertram.
Bernd Volk, Deutsche Bank’s covered bond strategist, says the decline in outstanding volume is mainly "a result of the maturing of grandfathered state-guaranteed bonds". Outstanding volume has declined since 2004 and last stood at Eu68.2bn.
Replacing public sector deals with new ones has been challenged by the fact that it is difficult to fund the assets on a viable margin. "Banking in Germany is not fun, there is huge competition in favour of end clients so loan margins are not great," says Bertram.
As a result, many local issuers have looked to plug the gap in their collateral pool with other higher yielding assets from peripheral Europe.
For example Greek, Portuguese, Irish, Spanish and Italian public sector loans back as much as 26% of DG Hypo and Hypo Real Estate’s public sector collateral pools, according to Engelhard at Barclays Capital. Similarly, Dexia Group’s collateral pool has a 10% exposure to these jurisdictions.
Notwithstanding these disturbing statistics, "German banks prefer to buy German Pfandbrief," says Bales, but in longer seven to 10 year maturities, he says. "German insurers and funds have a stronger willingness to diversify."
This German real money investor willingness to look to international markets has benefitted all covered bond issuers alike and helped to fill the enormous funding gap that they collectively face.
Covering the funding gap The Basel Committee on Banking Supervision estimated in January that banks face a collective funding gap of Eu2.89tr though to 2018 and stipulated how liquid banks need to be.
The Basel liquidity rules adopt a two track approach to measuring liquidity — the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The committee said these rules must be implemented by 2018.
Under the LCR bank investors will not be able to invest in the senior paper of other banks from 2015. This would theoretically mean only those senior bonds maturing before 2015 would be attractive, but in practice some banks are simply avoiding investing in senior bonds altogether, thereby compromising the senior sector in favour of covered bonds.
"Banks used to be strong investors of senior unsecured, but now they are hardly buying beyond 2014," says Bales.
Because covered bonds are effectively the only eligible bank funding instrument allowed in the liquidity buffers, their structural bid has been set in stone.
Aside from new liquidity rules, covered bonds have also benefitted from a further regulatory boost in the form of bank bail-ins. A European Commission draft consultation paper released in January said "certain exclusions" from bank bail-ins "might be necessary", counting covered bonds as one.
Credit buyers have therefore been looking at covered bonds and judging that bail-ins won’t apply.
And from an investor’s perspective, the regulatory backdrop is proving exceptionally conducive for long dated covered bonds. "High grade insurance and mutual funds are increasingly buying covered bonds — even with maturities longer than 10 years," says Bales.
The reason for that spike in interest has much to do with the onset of Solvency II, particularly in the case of UK insurers, who in the space of a few short weeks, have become one of the most important sources of real money demand at the long end of the curve.
These players had generally avoided investing in covered bonds, but in April 2010, Solvency II’s Quantitative Impact Study 5 (QIS5) was announced, a development which bankers said at the time would be favourable for covered bonds relative to corporate bonds.
The theory was that yield-hungry UK insurers, anxious to offset long liabilities, would invest much more heavily in covered bonds. In practice this did not transpire in 2010. However, this year that demand has taken off with a vengeance, as a string of UK issuers have brought sterling denominated long dated deals.
These include: Nationwide Building Society which issued a 15 year, Lloyds TSB, which issued an 18 year and Abbey which issued a 15 year. But, it’s not just UK borrowers in sterling that have benefitted. Several Italian and Spanish banks — such as UniCredit, Intesa and BBVA — have issued in euros and pulled in UK demand. "The UK cavalry has finally arrived and the universe of covered bond investors has exploded," says Jeremy Walsh, head of covered bond syndication at Royal Bank of Scotland.
No-brainer
This interest has as much to do with the changing regulatory environment as with spreads. The argument for investing in covered bonds, compelling as it already is, gets even more persuasive from an investor’s perspective, the closer a borrower’s spread is between its covered bond and senior unsecured debt.
"It’s a no-brainer as to which instrument you buy," says Mauricio Noé, head of covered bond origination at Deutsche Bank. "With covered bonds you have a dual recourse instrument that has significantly less risk of being bailed in."
The fact that many covered bonds trade close to their senior unsecured is largely because of their correlation with the domestic sovereign.
This is particularly conspicuous in the peripheral markets — namely Spain and Italy. But to some minds, this is not fully justified.
"Many investors are maybe putting too much emphasis on perceived sovereign risk," says Bales. For example, Intesa, UniCredit, Santander, BBVA and some UK covered bonds trade over 100bp wider than those in other jurisdictions, even though their senior unsecured rating is much better.
"Is that spread justified? They have a good senior unsecured rating, they are strong banks issuing triple-A bonds collateralised by mortgages, but in some cases their bonds trade even wider than senior unsecured level of banks from other countries."
UniCredit, for example, funded at mid-swaps plus 175bp for its Italian 12 year compared to plus 69bp for its 10 year Austrian public sector bonds and mid-swaps flat for its two year German Pfandbriefe.
"People price our Italian deal as riskier versus Pfandbriefe issued by our German bank," says Bales. But he acknowledges that "every issuer is financing very different assets," which may help justify these spread differences.