Covered bonds will survive a CRE extinction event
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Covered bonds will survive a CRE extinction event

CANGREJO HERRADURA O BAYONETA - ATLANTIC HORSESHOE CRAB (Limulus polyphemus), Isla Pasion, Isla de Holbox,  Estado de Quntana Roo, Peninsula de Yucata

Investors in the debt market’s living fossils have nothing to fear despite commercial real estate’s problems

Cracks are starting to appear in the commercial real estate debt market, thanks in part to a decline in demand, monetary tightening and the looming threat of a price correction.

And although concerns over the impact this might have on ABS or real estate investment trusts are filtering through the markets, those investors in their senior secured cousins in the European covered bond market have nothing to fear.

Covered bond investors will remain well insulated despite any exposure, thanks to the structure of a product that has evolved over almost 300 years.

For a start, covered bonds offer investors recourse to both issuer and the collateral. In the event of a default, investors can claim against the ring-fenced pool of assets each bond is secured upon and against the issuer as well. If a bank goes down and the asset pool becomes loss making, investors can still claw back their losses from the borrower.

And for the most part the underlying commercial real estate mortgages themselves have low loan-to-value levels, further insulating covered bonds from issues in the sector. Eurozone banks are mostly capped at LTVs of 60%, in line with the guidelines in the Capital Requirements Regulation, with up to 70% permitted in some instances if extra collateral is pledged.

As a result, commercial real estate loans pledged for covered bonds have a sizeable buffer to mitigate any drop in the underlying property price — and it would take a drastic realignment in commercial real estate pricing to eat away at this.

Furthermore, European covered bond law stipulates that firms must hold ample excess collateral to support their cover pools in the event of default. And even then, many lenders are overcollateralised well above their regulatory minimum targets.

More than 90% of covered programmes rated by S&P are able to withstand a one notch credit rating downgrade to the parent issuer before being downgraded themselves. Close to half could withstand a four notch downgrade.

The litmus test is how investors see the covered bonds of specialised commercial real estate lenders. So far, they appear confident.

Although paper from Aareal Bank — which has €13.1bn of commercial real estate debt in its cover pool — and Deutsche Pfandbriefbank — €15.4bn — already trades wider than its peers, their spreads have moved only in line with the broader market.

Elsewhere in the market, CRE mortgages make up a small share of asset pools. Instead, owner-occupied residential mortgages are the backbone of Europe’s covered bonds. Bluntly, there is higher demand for houses than offices.

This week investors placed orders of €10.25bn for €6.5bn of covered paper. The asset class has weathered all manner of market disruptions and this will be no different.

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