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Covered bonds: not so private after all

Despite long being lauded as one of the very few effective private sector solutions for wholesale mortgage funding, covered bonds are not quite so divorced from the state as they might seem. Strong implied state support is clear in the most longstanding regime — a pattern that is likely to be replicated in others.

Covered bonds are typically seen as an asset class capable of providing reliable private sector wholesale mortgage funding. In the wake of the subprime crisis, policymakers in the US are increasing seeing covered bonds as a funding saviour, particularly as they grapple with the prospective wind-down of Fannie Mae and Freddie Mac, as well as a still defunct private label RMBS market.

But as longstanding jurisdictions show — not least through some extraordinarily cheap funding levels — the success of the asset class relies implicitly on state support. And this perception is only likely to become more entrenched.

Muenchener Hypo recently completed a 10 year at 10bp over mid-swaps — just 10bp back of where KfW's 10 year paper was trading. Not long after, French borrower Caisse de Refinancement de l’Habitat (CRH), a systemically important institution, priced a tap of a 12 year at 103bp over.

What MuHyp offered that CRH didn’t was a perception of greater state support. This is even more conspicuous for smaller German issuers like Nordbank and Aareal Bank, who recently secured funding at low double digit spreads.

Domestic demand is fundamental for the German issuers, with 80% or more often going to those buyers. That is partly driven by the fact that domestic holders can invest without attracting any capital charge, but the zero risk weighting that is applicable to the German Pfandbreife held on the balance sheets of most of Germany’s second and third tier investors hardly reflects a genuine assessment of underlying credit risk. In most cases, Pfandbriefe are backed by very large portions of commercial real estate mortgage loans, which, being much larger than residential mortgage loans, are generally perceived to be riskier.

In the case of one borrower, as much as 90% of the pool was backed by commercial mortgages. These mortgages, even in Germany, are not in such great shape. Germany has the second largest CMBS sector in Europe, after the UK, and the rate at which underlying commercial loans are due to mature is expected to escalate sharply over the next two years. With the CMBS market closed, loanholders risk being unable to refinance. They may be obliged to put their property up for sale, pushing down commercial property prices. In the recent German Opera Finance CMBS workout, all except the senior noteholders took a loss.

And not collateral pools are even backed by German loans. In one recent covered bond, more than 80% of loans were originated outside the country — including a double digit percentage exposure to Italy. That kind of collateral doesn’t stack up too well against covered bonds that are backed exclusively by large, granular pools of performing prime, first lien residential mortgages.

Ratings are another issue: the senior unsecured rating for many small German issuers is in the range of low single A to triple B, making the second recourse back to the borrower look deficient in comparison to the large range of covered bond issuers that are double A.

Tight pricing is not just down to an overriding faith that the German state will protect covered bond investors at all costs. There are technical factors too. Net Pfandbriefe supply this year has fallen by about €20bn — roughly the same drop as last year. Assuming steady demand, this shrinkage means prices go up. And German funding is often startling cheap only on a mid swaps basis. Relative to Bunds, for example, Pfandbriefe spreads offer a hefty premium of 60bp-70bp, compared to the measly 15bp that CRH offered over the French sovereign.

Nonetheless, implied state support is an enduring factor in the pricing for the smaller German issuers in particular. With covered bonds more important than ever for the financing of European banks, this trend is likely to spread.

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