GlobalCapital and The Cover held a roundtable in November involving new issuers, well recognised names, a leading covered bond investor, and a Commerzbank debt capital markets executive to discuss some of the most pertinent factors affecting the covered bond market today, including relative value, the impact of the ECB’s purchase programme, issuers’ euro funding needs and their strategic marketing approaches.
Participants in the roundtable were:
Henrik Stille, portfolio manager,
Nordea Investment Management, Denmark
Karol Prażmo, head of treasury, mBank, Poland
Matthias Ebert, head of DCM bonds origination, banks overseas advanced markets, Commerzbank, UK
Mustafa Turan, head of international banking and
investor relations, VakıfBank, Turkey
Norbert Dörr, head of capital management and funding, Commerzbank, Germany
Wojtek Niebrzydowski, vice president treasury,
Canadian Imperial Bank of Commerce, Canada
Yeoh Hong Nam, head of wholesale funding,
DBS Bank, Singapore
Bill Thornhill, moderator, GlobalCapital
Impact of CBPP3
GlobalCapital: How has the European Central Bank’s third Covered Bond Purchase Programme changed your view on new issuers and countries?
Henrik Stille, Nordea Investment Management: The purchasing programme has increased our focus on new jurisdictions.
It’s forcing all investors to maybe pay a little more attention to new jurisdictions than they would have done otherwise.
Matthias Ebert, Commerzbank: If I understood you correctly, you just said that the covered bond purchasing programme was helping new issuers to come to the market because they offer an attractive spread over eligible paper. Does that mean you are rebalancing your covered bond portfolios?
Stille, Nordea IM: Yes, definitely. If it wasn’t for CBPP3 we probably would have had much less non-eligible paper in our portfolios. We look at these non-eligible markets much more closely because of the spread pick-up they offer. The pick-up has nothing to do with credit risk, it’s really only because of the impact of the ECB buying the eligible jurisdictions and not others.
GlobalCapital: The number of investors in Commerzbank’s September 2015 benchmark was half that in the September 2014 benchmark. Norbert, what do you think about that?
Norbert Dörr, Commerzbank: The ECB being a strong buyer didn’t directly have an impact on the number of private investors. The bigger impact was the spread compression, as well as the overall low level of interest rates. Covered bonds, for some of the investors, are simply too expensive so they would rather stay out of the asset class.
GlobalCapital: Henrik, have the spread tightening and low absolute yields caused you to stop buying?
Stille, Nordea IM: No, definitely not. I think it’s rather interesting that we hear there are so many investors exiting the covered bond market, but the question is what are they then buying instead? Because if you look at the spreads throughout 2015, they are certainly not buying senior bonds, because they’ve widened throughout the year, except for October’s reversal.
GlobalCapital: To what extent do you believe issuers are relying on the Eurosystem for support?
Dörr, Commerzbank: We’ve issued mortgage Pfandbriefe across various tenors this year in five, seven and 10 years. For us the participation of the Eurosystem wasn’t really a deal driver. While you know they’ll participate, they also have a clear cap. We could have placed equivalent deal sizes even without their participation. We didn’t want to be seen issuing an instrument where we are totally relying on the Eurosystem’s participation.
GlobalCapital: Wojtek, has the purchase programme been a help or a hindrance for Canadian issuers in terms of the spreads and the number of investors that you’re seeing?
Wojtek Niebrzydowski, CIBC: We tend to do things in rather an old-fashioned way. I’ve been in this business for a long time and I don’t ever recall the Bank of Canada buying commercial banks’ bonds. Our inaugural legislative European transaction — which was in July 2013 — was priced at 9bp over mid-swaps. For a little while after CBPP3 began there was spread tightening but now we’re back to the 20bp area so, arguably, we have not benefitted from a sustained spread tightening due to CBPP3.
GlobalCapital: How does that compare to the US dollar funding you got for your pre-legislative structured covered bonds?
Niebrzydowski, CIBC: There was no euro-denominated Canadian issuance from CIBC or anybody else between October 2008 and July 2013 because the basis swap was not viable. The average five year US dollar funding converted into euro equivalent in 2010-2012 would have worked out to around 20bp-30bp through Euribor.
GlobalCapital: Does it concern you that the ECB is displacing investors?
Niebrzydowski, CIBC: I think the predominant market view is that CBPP3 has had a disruptive impact, which has had an unintended consequence of displacing real money investors. That’s obviously something that would not be good for the market in the long term and would be of concern to us as an issuer.
GlobalCapital: Fewer investors are getting involved, which surely means CBPP3 is damaging liquidity.
Stille, Nordea IM: Actually, I don’t think liquidity is any better or worse than it was a year and a half ago. In fact, I would say liquidity has held up comparatively well in covered bonds. My colleagues in the credit team have seen liquidity deteriorate much more in other corporate fixed income markets, compared to covered bonds, over the past 18 months. Liquidity did clearly deteriorate during the sovereign debt crisis in covered bonds, but I see no difference at all in the last year and a half.
GlobalCapital: Karol, as a Polish issuer in euros, would you say CBPP3 has been helpful or not?
Karol Prażmo, mBank: We’ve been active in the euro market with smaller transactions and we are satisfied with the levels that we’ve been able to achieve. The purchase programme has had a meaningful and positive impact. Levels are likely to continue to improve when the new covered bond legislation comes into force in 2016.
GlobalCapital: Do you believe the side effects of CBPP3 make the euro market the best alternative?
Yeoh Hong Nam, DBS Bank: The euro market is certainly attractive when you look at the spread versus mid-swaps, but we find that the economics are approximately in line with what we can achieve in the US dollar market, plus or minus 5bp-10bp.
Some players count it in our favour that our covered bonds are not eligible for purchase by the ECB and come at a significantly wider spread than, for example, Pfandbriefe. In other words, the spread is more market-oriented, and investors can actually get their hands on bonds.
But CBPP3 is not the only attraction of the euro market. We like the fact it is a market with a long tradition in covered bonds, where investors are familiar with the nuances and able to differentiate between programmes from a multiplicity of jurisdictions.
GlobalCapital: What do euros offer you that dollars do not?
Yeoh, DBS Bank: Euro covered bond order books get a higher proportion of €10m-€20m orders from portfolio managers who have specific covered bond targets in their asset allocations. It’s harder to get your message across to such a widely distributed investor base, but if it is done properly it is possible to unlock considerable volume. Accessing the European client base also has the benefit of significant investor diversification.
Introducing DBS to this new group of investors has been helpful because many of them can also consider investing in the rest of our capital structure.
GlobalCapital: Henrik, what’s your view about the growing number of issuers and regions that are coming into euros?
Stille, Nordea IM: It’s an extra alpha source for us to add performance in our covered bond funds, so we follow all these new jurisdictions very closely and also new issuers of course within existing jurisdictions.
GlobalCapital: What’s the downside to investing in new markets?
Stille, Nordea IM: The biggest concern is secondary market liquidity. Take the Canadian market as an example: it is starting to behave better now, but two years ago it was a difficult market to trade. The same with the Australian and New Zealand markets, but they have also improved a little. But this is something that we need to pay special attention to before we invest.
Relative value
GlobalCapital: Where should new markets such as Turkey trade, relative to their sovereign and senior levels?
Stille, Nordea IM: Covered bonds can trade tighter than govvies in Europe because you have implicit systemic support. For example, there is an implicit assumption that the EU will probably support Spain or the Spanish banking system if something goes wrong, but you cannot assume this will be the case in Turkey.
So for these new jurisdictions outside the EU, I think they need to find a covered bond funding level somewhere between senior bonds and government bonds. Issuers should be able to fund themselves more tightly than with senior and investors should expect some pick-up over sovereign bonds. It’s going to be difficult for Turkish covered bonds to trade tighter than the sovereign, even though the covered bond rating is a little better. Covered bonds have been here in Europe for quite some time and investors know it is a systemic asset class, which is not the same in new jurisdictions.
GlobalCapital: Once you have established yourself with two or three or four outstanding deals, where would you like to see Turkish covered bonds pricing, relative to where the government prices?
Mustafa Turan, VakıfBank: It’s going to be a price discovery process during the rollout of the programme and its likely debut issuance may come slightly above the sovereign level. But you have to take into consideration two important things. The first is that the Turkish sovereign euro curve is unfortunately not as liquid as the dollar sovereign curve. So liquid Turkish covered bonds may not necessarily benchmark purely against the steep sovereign curve.
Secondly, our covered bond A- rating is three notches above the sovereign rating. This is of course an important feature because it’s changing the rating level from barely investment grade to a level which is firmly in investment grade, which I believe is of sizeable value. Maybe initially this notching uplift will not be enough to ensure tighter pricing than the sovereign, but I’m very confident that in the medium term it will. As long as the notching differential persists, tier one Turkish banks issuing euro covered bonds should eventually price through the sovereign.
The reason I am confident is because we are not just talking about a rating differential but bonds secured by high quality collateral, and issued under a well regulated, strong law which sets out exactly what should happen in the event of an issuer’s insolvency. The sovereign risk is not secured and investors have no post-insolvency legal protection.
So I’m definitely confident that in the medium term Turkish blue chip covered bonds will come through the sovereign. And post-swap costs, the funding has to be meaningfully through our senior curve to reflect the value of the collateral. We already have an example with bilateral Turkish diversified payment rights securitization, which in the last three years has come through the sovereign. This is because they had an A- rating from Fitch, which is very important. And don’t forget, DPRs don’t actually have a physical form of collateral, unlike covered bonds.
GlobalCapital: How has the covered bond purchase programme affected the value of covered bonds relative to senior unsecured, and to what extent has the Bank Recovery and Resolution Directive (BRRD) played a role?
Ebert, Commerzbank: In 2015 there was a widening of the spread between double-A and single‑A rated senior unsecured and triple-A covered bonds. I believe the implementation of the BRRD and the effective subordination of senior bonds in some European countries were the main drivers for this widening. Senior spreads started widening in March 2015, just as Germany released its Single Resolution Mechanism adoption act proposal. On the other hand, we have the CBPP3: one very large buyer that has kept covered bond spreads artificially tight.
GlobalCapital: Do you think covered bonds present a good investment opportunity?
Stille, Nordea IM: There’s still a lot of value in covered bonds at current levels, relative to senior bonds. For example, if we look at the short end of Santander’s curve, senior only trades around 30bp wider than covered bonds, which is at the low end of the two year range. So it seems the market so far hasn’t priced in the implementation of BRRD, which makes the covered bond asset class look attractive relative to senior at current levels. I’m very much in favour of being long covered bonds and short senior bonds at current levels, especially in the periphery.
GlobalCapital: What’s your view on the outlook for spreads between bonds eligible for CBPP3 and those that are not?
Stille, Nordea IM: Over time this spread difference will compress, but whether that happens in the next month or in six months or in two years, it’s difficult to say. But the risks going forward are very asymmetric at current levels. It’s very difficult to see spreads going wider from current levels so either they will stay where they are, or more likely tighten a bit.
GlobalCapital: Do you prefer CBPP3 eligible or non--eligible bonds at this point in time?
Ebert, Commerzbank: Non-CBPP3 eligible spreads have widened relatively significantly since the middle of the year and they look very attractive compared to CBPP3 eligible covered bonds, but also to bonds eligible for the QE programme.
Stille, Nordea IM: We clearly prefer those jurisdictions that are not eligible for the programme at current levels. As for CBPP3 eligible deals, current levels versus government bonds are pretty much back to where they were in the fourth quarter 2014.
GlobalCapital: How about covered bonds’ relative value to SSAs?
Ebert, Commerzbank: In the first quarter of 2015 when the ECB QE programme was introduced, there was a relatively strong rally in eligible agency and sovereign paper. As a result, covered bonds looked very attractive vis-a-vis SSAs and the share of private investors increased, while the central bank share dropped from its high levels in the fourth quarter of 2014. During the course of 2015, relative value for covered bonds versus SSAs was volatile. At the moment, relative value is again improving for covered bonds, but we are not yet back to first quarter 2015 levels.
GlobalCapital: Where do you see value between covered bonds, supras and govvies?
Stille, Nordea IM: I don’t see supras as being more attractive than covered bonds at current levels, I think they are fairly valued. The levels where you can buy ESM bonds, for example, compared to Norwegian, Canadian or UK covered bonds, is fair. So I wouldn’t overweight SSAs to covered bonds at current levels, but I would like to overweight SSAs to government bonds.
Funding needs
GlobalCapital: Can you tell me about your deposit ratio, mortgage growth and expected covered bond funding?
Yeoh, DBS Bank: DBS Bank has a 52% market share of the low cost Singaporean current and savings accounts market and this forms more than 90% of our Singapore dollar deposit funding. At the same time, our Singapore dollar loan to deposit ratio is below 85%, which means we have considerable scope to expand the mortgage book. Our real challenge is that we are already the dominant player in the mortgage market, with a 23% market share, so gains from here are harder.
GlobalCapital: What is the main complication you face with respect to issuing covered bonds?
Yeoh, DBS Bank: Our constraint derives from the issuance cap imposed by our regulator [the Monetary Authority of Singapore], which is set at 4% of assets. This restricts our ability to issue covered bonds to a maximum of approximately $10bn, which our mortgage portfolio is easily able to support. We will apply to our regulator to raise this limit as we approach it and we are cautiously optimistic that they would look kindly on our application.
GlobalCapital: Can the domestic investor base for Polish covered bonds fund growth in your mortgage loan book?
Prażmo, mBank: We’ve been active in the domestic market for about 15 years, and certainly it can provide a meaningful portion of our funding, but not the entirety. We are seeing reasonable growth in our residential mortgage loan activity and we intend to fund the majority of that in the domestic market. However, a material portion of our cover pool is euro-denominated, so we have a natural need to issue euro paper as well. That natural need to match fund euro assets with liabilities means we’ll be active in euros.
GlobalCapital: How much euro supply can we expect from mBank and Poland next year?
Prażmo, mBank: We effectively doubled supply from 2013 to 2014, and for 2015 we expect to be up another 50% from last year. We expect to issue between Z1.5bn and Z2bn next year, which means up to €500m. A number of the Polish banks are getting themselves reorganised to issue covered bonds and take advantage of new covered bond legislation which comes into force on January 1, 2016. It is likely Polish covered bond issuance will materially grow next year to around €1bn-€1.5bn equivalent.
GlobalCapital: And Wojtek, how about your issuance plans for next year?
Niebrzydowski, CIBC: The two principal moving parts are funding needs and economics. I would expect somewhere between three to five benchmark sized transactions from CIBC. However, that would be likely across all five currencies that we’ve historically been active in. Speaking specifically about the euro market, I think I would reasonably be looking at one, maybe two benchmark sized transactions, which traditionally for Canadian issuers have been €1bn or more, but we will obviously be looking at that in the context of market conditions.
GlobalCapital: Mustafa, you have seen tremendous mortgage growth in Turkey. Are you hoping covered bonds can help fund this expansion?
Turan, VakıfBank: The Turkish mortgage market is relatively small and in aggregate is equivalent to just 7.5% of Turkish GDP. So there is still a sizeable growth opportunity, especially for big lenders like VakıfBank. We are number three in the market, with a portfolio of around TL15bn of residential mortgages, around 12% of our loan book. Turkish deposits, especially for big tier one banks like us, are deep enough to fund the marginal growth in mortgage lending. This means Turkish bank liquidity can comfortably fund mortgage lending. The problem is, and this is where covered bonds can help, the low duration of Turkish lira liabilities.
GlobalCapital: They’re too short?
Turan, VakıfBank: Exactly. On the one side you have deposits up to six months, and on the other you have residential mortgage loans with a weighted average life of three to five years. This means you are running a sizable duration mismatch. So the main idea behind mortgage-backed covered bonds is to lower the duration mismatch. Banks need the medium term funding that covered bonds provide. Unfortunately, local covered bond demand from insurance companies and the like is not available in the Turkish funding market right now.
GlobalCapital: What term funding can you get from senior unsecured and equity?
Turan, VakıfBank: We have issued senior unsecured in euros and dollars in the five to 10 year range and some equity, but this is not designed to fund our mortgage book. Turkish banks typically try to raise hard currency medium term debt in the international markets and then use cross-currency swaps to create long term Turkish lira funding. They then try to hedge their mortgage books in Turkish lira. But even so, there’s a lack of long term Turkish lira on the liability side.
GlobalCapital: So when can we expect your first euro deal?
Turan, VakıfBank: Who knows? Maybe before the end of this year or early next year. We are ready to come to the market as long as we believe the pricing works and, of course, investors have appetite. So the Turkish covered bond story actually starts now, rather than the last two years’ private placements. Our deal has a provisional A3 rating from Moody’s and we plan to incorporate the EBRD as an international financial institution to support the transaction. So maybe it is possible to issue the debut deal with a five year maturity in €500m benchmark size.
GlobalCapital: One of the big factors that has been difficult with the Turkish market is the cost of the swap. Can you tell me about these challenges?
Turan, VakıfBank: The swap is essential, not only because of the currency, but also for the rating. The inclusion of transfer and convertibility (T&C) risk mitigation was the key element rating agencies required to assign the A3 rating. So we have to make at least one swap, registered under the cover pool, to reach this rating. On the other hand, if issuers don’t feel comfortable about the costs of turning euros into Turkish liras, it is necessary to incorporate a back swap. This allows the bank to pay euros if the cross-currency rate during the issuance day or days is not at the desired level. That’s probably the approach that VakıfBank will follow, unless the Turkish lira cross-currency market improves substantially.
GlobalCapital: Am I right in thinking each covered bond can be rated separately?
Turan, VakıfBank: Our programme is tranche-rated, to give us the flexibility to change the overcollateralisation ratio to get different ratings, and also so we can use different rating agencies. This is the approach we use in diversified payment rights securitization programmes that Turkish banks have been using successfully for many years. Having said that, the OC level for our debut deal will be at the minimum 20% threshold, which is drafted in the programme documentation and accepted by Moody’s.
Marketing
GlobalCapital: What do you look for before buying covered bonds from new markets?
Stille, Nordea IM: We don’t really have any major constraints. For example, we can buy covered bonds that don’t have index eligibility, we can buy them if they don’t have a rating, and we can buy soft bullets or conditional pass-through bonds. We don’t have any country restrictions either. But again, if any of those factors are lacking, we need to be compensated with a higher spread.
GlobalCapital: Henrik, do you have country limits for more established markets such as Canada?
Stille, Nordea IM: We have no limits, but we do have specific mandates for our institutional clients where the limit can be more restricted. Typically, these specific institutional mandates restrict the amount of non-EU jurisdictions we can hold in the portfolios. If it’s our own mutual funds we don’t have many limits.
GlobalCapital: Do you believe there is merit to issuing across a range of currencies, or should borrowers prioritise a strategic role by issuing mainly in one currency?
Ebert, Commerzbank: I think there is an advantage for issuers to have a balanced approach to the market and issue over a number of currencies regularly, rather than flooding one single currency. Issuers with a presence in different currencies usually find it easier to exploit arbitrage opportunities. But a regular presence in a number of currencies is difficult to achieve if funding needs are limited. I think that brings us to the question of how often issuers should tap a market, to be regarded as a regular issuer.
GlobalCapital: How do you intend to approach the European market and prepare your own covered bond offerings?
Yeoh, DBS Bank: There is no substitute for getting out and meeting investors. We find attending conferences such as the European Covered Bond Council event in Barcelona this year very useful. We are also taking steps to follow established market practices where possible. You could say we are trying to provide a local implementation of European best practices. Other than this, Singapore has also been awarded the ECBC covered bond label. We are hopeful that this will make it easier for investors to understand our credit story and identify similarities with programmes of other strong issuers.
GlobalCapital: Is there a risk borrowers spread themselves too thinly by issuing, potentially infrequently, over a range of currencies, rather than prioritising one as strategically important?
Stille, Nordea IM: Diversified issuance in a range of currencies is always good but I think it’s something that the frequent issuers should do. Borrowers that only issue once a year should not start to work with different currencies until they have built up a curve in at least euros or US dollars. New issuers should probably stick to euros or dollars until they have done three, four or five deals and not start to experiment too much with the smaller currencies from the beginning. If you issue twice a year, that’s enough for us to view the borrower as being a regular.
GlobalCapital: Matthias, what’s the benefit of defining a strategic funding currency?
Ebert, Commerzbank: There are benefits for investors and issuers to build a curve and have a regular appearance in one currency, because an outstanding curve in the market provides reference points and creates certainty around pricing for a new issue. Moreover, investor marketing is time-consuming, but continual efforts in one region make a difference. So I think it’s an advantage to focus mainly on one region if your funding needs are not too large. On the other hand, for borrowers with larger funding needs, it’s good to diversify in a range of currencies, because in the past we’ve seen markets can close. We saw it around the Greece crisis, and in the summer when concern about China kicked in.
GlobalCapital: What are your thoughts about funding across a range of currencies?
Yeoh, DBS Bank: Euros is not the only market we can access. We are also looking at sterling and Aussie dollars.
GlobalCapital: What is the potential for supply from your region in euros and dollars?
Yeoh, DBS Bank: Based on the 4% encumbrance limit I referred to earlier, Singaporean banks would be able to issue $25bn-$30bn of covered bonds. Extrapolating DBS Bank’s considerations to the wider group, we could see a volume split by currency of 50% US dollar, 25% euros and 25% others, such as sterling and Aussie dollars. The US dollar market is an important trade finance currency for Asia, while the euro market offers a wider investor base.
GlobalCapital: Yet it seems, based on your inaugural deal, that you can reach European investors with dollar issuance, and, in a sense, get the best of both worlds. Was that your experience with your inaugural dollar deal?
Yeoh, DBS Bank: The covered bond was distributed internationally. Thirty percent was placed with European investors, 19% to the US and the rest to Asian buyers. This shows that the establishment of this programme and subsequent conversations we had with investors did indeed help us diversify the investor base globally, compared to our US dollar senior unsecured bonds.
GlobalCapital: The covered bond market is obviously deeper in euros, but then I guess VakıfBank’s name has been more familiar in the senior unsecured market in dollars. What are you looking at in terms of whether you will be using dollars or euros?
Turan, VakıfBank: We’re not targeting emerging market investors, our target is to diversify our investor base and hopefully place bonds to the real covered bond investors. It doesn’t make sense for our regular EM investors, who are actually happy to take our senior unsecured risk, to buy covered bonds. That’s why we are in the euro covered bond market in the first place. But in the future, if the dollar gives us a better edge, why not? We will be very happy to issue in dollars or, who knows, some sort of 144A drawdowns may be possible in future as well. But initially we will focus on European covered bond investors.
GlobalCapital: Karol, what are your thoughts about approaching the euro market?
Prażmo, mBank: A sustained marketing effort is very important. In the last 18 months we’ve done about 10 small euro transactions as part of our determination to get investors familiar with our product. In 2016 we are going to have a very broad effort to discuss the Polish economy, the Polish residential and commercial real estate markets, the new covered bond legislation and our credit story.
So 2016 is going to be a year of education, as we scale our activities in a meaningful manner.
GlobalCapital: Wojtek, can you tell me about your approach to marketing your covered bond programme in Europe, specifically after the Canadian law change, and how that process has continued?
Niebrzydowski, CIBC: We first issued in euros in 2008 from our structured programme, and though we were absent from the market for a number of years thereafter, we made a deliberate effort to maintain a presence in front of the key investors. We were ultimately reasonably confident that at some point the economics, for us as a Canadian bank, would turn.
Well, they did turn in 2013, which was a lucky coincidence, as Canadian legislation had come a few months earlier. Notwithstanding that, most, if not all, of our Canadian peers at that time were principally focussed on the US dollar market. We made the effort to introduce Canadian legislation to European investors in July 2013 and we followed with our inaugural legislative trade.
We’ve been marketing in Europe fairly regularly, either in the context of Euromoney, IMN or private conferences, or in the context of our own organised trips focusing on certain markets. We believe it’s important to keep our name in front of investors, even if it’s for the purpose of saying nothing’s changed in the context of the sovereign, the banking system, our own credit and our issuance plans.
GlobalCapital: So continuing to keep in contact with the investor base in Europe, no matter what the market conditions are, seems to be the message.
Niebrzydowski, CIBC: Absolutely. That’s what we’ve been doing.
GlobalCapital: What’s your view on the growing number of new candidates that we’ve seen and that are expected to issue over the next year or two?
Niebrzydowski, CIBC: We generally view it as a positive development, as we believe new issuers should ultimately result in new investors, greater liquidity, more trading and so on. So expansion of the market should in theory be beneficial for covered bonds. That’s exactly the view we espoused in 2010 when CIBC, followed by other Canadian banks, effectively created the US dollar covered market in its current form, following the 2007-2008 crisis. At that time we were fairly clear we didn’t want the US dollar market to be a Canadian phenomenon only, and we were very encouraged to see selected core European countries and Australians follow with their own covered bonds.
GlobalCapital: Norbert, as a core European issuer from an established covered bond market, what’s your view on this point?
Dörr, Commerzbank: The more the number of issuers, the greater the market’s overall acceptance of the product and attractiveness. But then you have to differentiate yourself: either by your country’s strong legislation, as for instance we have here in Germany, or by the connection to your overall business model. If you are a strong national market participant with a good presence in retail mortgages, covered bonds are a natural funding instrument. This includes that you should be able to show some continuity in your issuance.
Ebert, Commerzbank: We have the impression that more and more non-eurozone issuers are looking at the euro market, which seems to be the deepest, best established market for the product, with the largest number of investors. The reallocation of funds within the asset class in favour of non-eurozone paper will help to digest the new supply. The low euro yields, in combination with very tight spreads, however, have led to a situation where European investors are leaving the asset class and demand has begun to dry up a bit.
As a result, there might come a time when there is less demand chasing more non-eurozone supply. That supply-demand imbalance might create challenges for non-eurozone issuers looking to enter the euro market. So I think there could be two ways to deal with this for the involved parties. Non-eurozone issuers, as Wojtek commented, can do more marketing in Europe to broaden the investor base, and eurozone issuers can look at foreign currencies, to be prepared in case demand in the home market gets diverted into non-eurozone peers with more attractive spreads.
GlobalCapital: Wojtek, do you believe there is merit to having a multi-pronged issuance strategy?
Niebrzydowski, CIBC: The US dollar market doesn’t have such a favourable regulatory approach as euros in terms of central bank repo eligibility, liquidity coverage ratio inclusion and so on. And euros is without any question our primary market and, for as long as it works, we’re going to be there. But CIBC generally swaps all euro funding back into either Canadian or US dollars.
So, even though we were confident demand would be there between 2009 and 2012, the cost of euro funding was maybe 25bp-50bp wider than our domestic, Canadian dollar senior unsecured, so at that time euro covered bond funding didn’t make any sense. For those reasons we need to fund globally, and aim to establish our presence in a number of markets, where we would like to issue once every 12-18 months.
GlobalCapital: I’ve heard that the dollar swap curve is pretty steep and it is not cheap to go much longer than five years in US dollars. In euros demand is deeper and the curve flatter at the long end.
Niebrzydowski, CIBC: It’s a bit academic for us, as the average duration of the Canadian residential mortgage book is about 3.5 years, which means the most active dollar issuers don’t have a funding need in longer maturities.
GlobalCapital: We’ve heard Wojtek talking about the basis swaps affecting the viability of euro funding, but looking forward to next year and a potential expansion of the QE programme, do you believe this may have consequences for the euro-dollar basis swap?
Ebert, Commerzbank: If QE is expanded, asset scarcity in the eurozone will probably increase and this may lead to a situation where dollar-euro cross-currency swap costs increase for non-eurozone issuers, as we saw in the first quarter of 2015. However, at that time, Canadians and other non-eurozone issuers still tapped the euro covered bond market, which shows there were other factors.
The funding equation is composed of several moving parts. One is the secondary market in dollars; then you have the cross-currency basis swap with three months to three months, then you have the three month to six months basis in euros, and finally the euro secondary market. Subject to how QE expansion is designed, we could end up in a situation where the cross-currency basis swap becomes less favourable for non-eurozone issuers due to increasing asset scarcity, but secondary market spreads in euros tighten to a greater extent — meaning euro issuance is still a viable option for non-European banks, relative to dollars.
GlobalCapital: So if I understand you correctly, an expansion of QE may push the dollar/euro swap further into negative territory, which would per se make dollar funding more attractive for non-eurozone issuers. On the other hand, the development in the dollar/euro swap could still be offset by the relative cheapness of euro funding compared to dollars in the future.
Ebert, Commerzbank: This is correct.
BRRD and regulation
GlobalCapital: Norbert, Germany has already introduced its version of BRRD. How is this going to change covered bond funding, compared with other asset classes?
Dörr, Commerzbank: We have the regulatory framework pretty much defined, and how different products will be treated in bail-in is relatively clear. What we do not know is how much MREL (Minimum Requirement for own funds and Eligible Liabilities) each individual institution has to hold. I don’t expect that we will be told that number any time soon, though according to the regulatory timeline this is supposed to happen beginning of next year.
Our approach is to first ensure that we meet regulatory requirements in terms of capital and MREL. That will then drive, to a certain degree, the amount of senior unsecured we need to roll over. This activity also contributes to our term funding, as well as deposit growth. Any residual funding needs then are ideally met with covered bonds, which we view as a pure funding instrument. Given the development of our cover pool eligible assets, in particular in our business segments Private Clients and Mittelstandsbank, I expect this covered bond funding to remain consistent with what we have seen in recent years.
GlobalCapital: How is BRRD progressing in Canada and Poland?
Niebrzydowski, CIBC: We had a federal election in Canada last month, with a change of government, and it is not clear whether finalisation of the resolution regime will be at the top of the new government’s priority list. We generally expect Canadian covered bonds to be in line with international rules and be exempt from bail-in.
Prażmo, mBank: The same thing, frankly, in that it has been delayed. By the way things are looking at the moment, I think Poland’s version of the BRRD will be seen around mid-way through next year.
GlobalCapital: Germany has already implemented its version of BRRD this year, but one thing people are still grappling with is the European Commission’s proposal to harmonise European covered bond frameworks. Norbert, does harmonisation really make sense, when it might dilute stronger legal frameworks?
Dörr, Commerzbank: What should be kept in mind when thinking about harmonisation is the inter-connectedness of national covered bond frameworks with national insolvency law. There are reasons why different covered bond frameworks have grown as they are. So, in my opinion, great care should be taken when trying to enforce something at the European level.
GlobalCapital: What is your best hope and your worst fear for harmonisation?
Stille, Nordea IM: We recognise that for issuers there are some benefits to having harmonisation. But as an investor, I believe it will only make the asset class more boring. The differences between the jurisdictions today are what creates opportunities in the market. The market’s reaction to certain events will differ across diverse legislative jurisdictions and this is what creates opportunities. So the worst outcome would be a totally harmonised market and the best outcome would be pretty much if matters were left as they stand today.
GlobalCapital: Do you think there’s any good in potentially harmonising some aspects of the market on a voluntary basis in certain jurisdictions, which are fundamentally not matching up to the best practice outlined by the European Banking Authority last year?
Stille, Nordea IM: There are some aspects that can improve a little. But I believe it’s up to the issuers in each jurisdiction to explain to the investors the benefits of their legal frameworks and why they think it is good as it is. And then it’s up to us, as investors, to compare these differences and make an investment choice.
GlobalCapital: The law change in Poland comes into effect in January. Can you give us a quick overview of how things will change?
Prażmo, mBank: In the event of the bankruptcy of the issuer, the maturity of all covered bonds is extended by one year. In that time certain tests are conducted and if one or more of them fail, the bond repayment schedule switches to conditional pass-through. The second large change is the elimination of withholding tax on interest paid to foreign investors, which frankly has been a big bottleneck to the market’s development.
There are also a series of other changes that should lead to a material improvement in ratings, such as mandatory overcollateralisation of 10% and the introduction of a six-monthly liquidity buffer. We have also increased the loan to value threshold on residential mortgage loans from 60% to 80% and removed the mandatory regulatory call option that the issuer had after five years from the time of issuance.
GlobalCapital: Now we have had elections in Poland, do you believe the political backing for the asset class has changed?
Prażmo, mBank: The elections will not change the fact that covered bonds will become an important funding tool for Polish banks. Further, the election happened only 10 days ago and the new government is still being formed. What’s important to highlight is that political rhetoric changes from election campaign phase to actually governing and policy implementation.
The tone is already starting to be more measured and from my perspective there is increasing recognition that a healthy banking sector is in the broader public interest. Hence, I’m positive about the development and growth of Polish covered bonds as we look into 2016 and beyond. This funding tool will become an important driver for the growth of the mortgage market in Poland.
GlobalCapital: Turkey has also held elections recently. What’s your prognosis on the political outlook there?
Turan, VakıfBank: After about 13 years of single party government, June’s elections created a possible coalition scenario, but the failure to form a coalition elevated political instability, which affected the risk premium for all Turkish assets. On the other hand, November’s election result was very positive in terms of delivering a strong, single party government. This is the best possible outcome and has fuelled optimism in the Turkish financial markets.
The political risk premium, which had been elevated, is no longer on the table. Turkey will not need to go to the polls for four years, which is extremely valuable because historically the Turkish economy has always done well during periods where there have been no elections. Having said that, there are still geopolitical risks regarding emerging markets. In any case, we believe Turkish GDP will grow in line with improved consumer confidence and we now have a positive bias towards 2016, as long as global market conditions don’t create a big negative surprise.
GlobalCapital: What’s happening about the Swiss franc mortgage loan exposure on Polish banks balance sheets?
Prażmo, mBank: We’re talking about roughly Sfr35bn ($34bn) overall loan exposure across the Polish banking sector. Several proposals have been discussed during the course of 2015. However, a new government is taking office and their approach to this topic remains an open question. In the context of covered bonds, it is important to highlight that we have no Swiss franc mortgage loans, either in the cover pool or in the mortgage bank.
GlobalCapital: Henrik, we’ve heard about the Polish law changes introducing soft bullets and conditional pass-through structures. Do you believe consent solicitations asking for these changes adequately compensate investors for the extension risk they are being asked to bear?
Stille, Nordea IM: I think it’s strange that weaker banks pay the same as stronger banks. The difference should be much higher. For example, the fee Monte dei Paschi paid for moving to a conditional pass-through was comparable to what Lloyds paid for moving to soft bullet, but the risks investors were being asked to take were vastly different.
GlobalCapital: Do you believe this may have something to do with the macro backdrop, with the ECB throwing money at everything, resulting in spreads not reflecting credit risk?
Stille, Nordea IM: Yes, in general spreads are rather compressed and if we return to a more normal market then I assume conditional pass-through covered bonds from weaker banks would trade much wider than hard bullets than today.
GlobalCapital: Norbert, there has been talk of introducing soft bullet maturities in Germany. What do you think about this?
Dörr, Commerzbank: I’m not sure whether it would be right to soften legislation and I personally wouldn’t see any advantage, rather question marks.
GlobalCapital: What are the key features of Singapore’s covered bond framework?
Yeoh, DBS Bank: The Singapore covered bond framework is regulated under Monetary Authority of Singapore’s Notice 648, issued pursuant to the Banking Act. It is important to note that all Notices issued by MAS are legally binding on the banks.
Under MAS 648, a bank incorporated in Singapore can issue covered bonds backed by residential mortgages. The transfer of loans to the covered bond guarantor (an independent legal entity incorporated in Singapore) can either be through equitable assignment or a declaration of trust. Notice 648 mandates an overall encumbrance limit cap of 4% of the total assets of the issuing bank (excluding assets earmarked for regulatory reserves).
The other key features of MAS 648 are comparable to the Australian covered bond framework and include a minimum OC of 103%, appointment of an asset monitor and establishment of a risk management framework by the issuing bank.
GlobalCapital: Can you tell me a little about the Turkish legislation?
Turan, VakıfBank: Legislation is in line with international standards several years ago, but in January 2014 it was amended by the Capital Market Board of Turkey and put into law. The covered bond market is regulated by CMB, with English and Turkish law governing the transaction documents.
The main features include cover pool protection, independent cover pool monitoring, which in our case is KPMG, and cover matching principles. The currency swap incorporates transfer and convertibility risk mitigation. Investors have priority claims over the ring-fenced cover pool and an unsecured claim that ranks alongside senior investors.
The swap provision also contains replacement and collateralisation triggers, so if the swap counterparty is downgraded they are obliged to post collateral and/or if they fall below certain thresholds, they have to be replaced with some higher rated institutions.
GlobalCapital: Turkish covered bonds are structured with soft bullets, is that correct?
Turan, VakıfBank: It’s a soft bullet programme and normally there is an 18 month extension period.
GlobalCapital: What are your views on conditional pass-through covered bonds? Because potentially they could be quite helpful for Turkish banks from a rating perspective.
Turan, VakıfBank: During the initial structuring period, those were not very popular, so we developed a soft bullet, which was designed to give us the best possible rating outcome at that time. But if rating agencies are going to start giving credit for pass-through structures beyond what we have with the soft bullet, then why not?