With so much focus on the property sectors in peripheral Europe, particularly in Ireland and Spain, investments backed by portfolios of mortgage collateral might not seem like an obvious choice for portfolio managers today.
Yet peripheral borrowers have provided a big chunk of volume in covered bonds so far in 2013. Buying from issuers across Spain, Italy, Portugal and Ireland, investors filled their boots with just under 10bn of paper over the course of January.
Spanish and Italian borrowers accessed the market sporadically at the start of 2012, before going very quiet until the third quarter. But one deal stood out as taking advantage of pent-up demand among covered bond investors Bank of Ireland, which brought the first covered bond from an Irish borrower in three years last November.
The borrower priced a 1bn three year trade at 270bp over mid-swaps, with a 2.5bn book. A defensive maturity, yes, but a big step forward nonetheless.
Before that deal, by the issuers own admission, BoIs secondary spreads were at unsustainably high levels. But to investors looking at Irelands recovery story on a macroeconomic level, covered bonds from the nations poster boy must have seemed like a bargain.
BoIs deal was the first peripheral notch on investors bedposts, and many more have come since. But the recovery of the asset class began some time ago, deep in the secondary market.
"Demand was already there, but borrowers didnt want to print," says David Loughran, FIG syndicate at Santander. "Bank of Ireland bit the bullet and the trade was a blowout because there was so much pent-up demand."
Hug a hedgie
So how did this demand build up? According to Anthony Tobin, executive director on UBSs FIG syndicate desk, speculative investors such as hedge funds may have had a hand in revitalising the market for peripheral covered bonds.
"The recovery story within sovereign markets is driven by governments, their fiscal activity, and their interaction with central banks," he says. "Investors then look to play into that recovery story on a macro level. The earliest players look to pick up blocks of bonds at distressed levels, or blocks of loans.
"You begin to see secondary flows improve in covered bonds, which makes levels more palatable. Investors are looking to buy something and make a 10%-15% return on it, through return on equity, or because theyre anticipating an upcoming liability management exercise, or something similar."
Many such investors are unfussed when it comes to asset class, picking up any instrument they can get their hands on so long as it gets them exposure to a market they believe will rally. Sooner or later, they will take profits, handing over the baton to the next wave of investors, says Tobin.
Higher beta real money accounts looking for value compared to other fixed income asset classes may then get involved. With todays low yields, investors looking for a decent return can go down the capital structure and buy subordinated debt from core European names, load up on government debt from eurozone sovereigns or pile into covered bonds from peripheral banks.
The third phase, says Tobin, is when traditional covered bond buyers return to the market, again looking for juicy coupons.
"There arent that many alternative investments to get that kind of return," says Tobin. "Youre either in the peripheral market, or you have to buy subordinated instruments. Activity in the subordinated space shows that it is not without risk, and covered bonds have a much bigger safety net."
This helps drive secondary spreads tighter and creates pent-up demand for primary issuance. But Loughran at Santander points out that it isnt just hedge funds that have helped along this secondary market recovery demand has come from real money investors from the start, he says.
"At the start, when peripheral covered bonds were still trading at distressed levels, there were a few of the smarter real money investors involved, not just hedge funds," he says. "As January progressed it was clear that almost everybody was buying. I couldnt point to a single country as the main driver."
Riding the rally
Confidence in peripheral covered bonds has been driven partly by the broader economic recovery in those individual countries. But as with other asset classes, covered bonds also benefitted from European Central Bank president Mario Draghis pledge in July 2012 to do "whatever it takes" to save the single currency.
Investors looking to ride that rally could have bought into any asset class. But the nature of covered bonds makes them a safer bet for investors looking to gain exposure to the recovery in peripheral economies without subjecting themselves to volatile government bond markets.
"Before the Draghi put, the market for peripheral issuers was very limited," says Laurence Ribot, head of flow syndicate at Natixis. "We went from there being almost no market at all to seeing strong consolidation in the government bond market. Levels started to appear attractive again.
"That brought back some investors who hadnt considered these borrowers for some time, and for issuers, we were back at levels which were more acceptable.
"Its true that in the secondary market there is not much liquidity, but covered bonds are much more stable than the government bond market. And from an investors point of view, it can be a more interesting place than the government bond market."
The Spanish market in particular has been a hive of activity in 2013. Bankinter was the first to break in, with a 500m long three year trade at the start of January, which was priced at 200bp over mid-swaps. The next time it brought a deal, it got an extra year and a half of maturity for the same price.
Lesser-known Kutxabank also gained access, bringing a 750m four year trade at mid-swaps plus 200bp. The issuer, which was formed following the mergers of BBK, Kutxa and Caja Vital Kutxa at the start of 2012, drew on its strong capital ratio to attract a book that was five times covered. The trade proved there was strong demand for Spanish risk, even new borrowers without much of an outstanding curve.
Strong peripheral borrowers typically national champions like UniCredit, Santander, BBVA and Intesa Sanpaolo but also some lower tier Italian names have also printed in senior unsecured.
But for many lower tier peripheral issuers, printing senior debt is simply not an option although spreads have rallied considerably since last summer, it remains too expensive. Covered bonds offer a cheaper option, albeit at the expense of collateral. Kutxabank, for example, priced an astounding 70bp through its curve.
There is also a tight spread differential between covered and senior, which makes covered bonds a better bet for investors, says Loughran at Santander.
"From an investors point of view, if the differential between covered and senior is small, then you might as well take the covered because youre getting greater security for a small drop in spread," he explains. "But if the differential is wide, then you could be more inclined to take the senior, because youre getting rewarded for the added risk."
Those that have issued are in a strong position. They have proved they can access capital markets funding even if they have paid up for the privilege and can now watch their bonds perform in the secondary market.
"Peripheral banks were under a lot of pressure at the start of the year," says Santanders Loughran.
"They had to show they had access to funding, whether because of pressure from regulators, governments, shareholders or ratings agencies. Theyve proven that point, and now they can sit back, watch spreads tighten and manage their balance sheets in a more economical way. Most banks are in strong positions and some of those guys will be looking at issuing senior debt now."
The balance is definitely in issuers favour. Investors cannot get their hands on enough paper, and the outlook for supply is bleak. Even Italian borrowers, which might have been expected to suffer heavily in the wake of an inconclusive general election, have been fairly stable in the secondary market.
"Italian borrowers have limited oustandings and issuance is likely to be limited this year," says Ribot at Natixis.
"So there is a shortage in terms of supply, but on the other side you have investors who are keen to buy Italy and can manage the volatility linked to the political situation. Yields have moved a bit but not that much its not a huge swing."
Despite the strength of the rally in peripheral debt, some are bearish on the long term outlook for covered bonds.
Picking up on incredibly strong demand for Cédulas Hipotecarias, ratings agency Moodys released a report in March warning of the fundamental risks facing investors.
"Spanish covered bonds exhibit strengths, such as being backed by the whole mortgage book and legislative support," it said.
"However, we believe that systemic risks overshadow these strengths and skew risks to the downside. Although we believe Spanish mortgage covered bonds offer protection in different adverse scenarios, they cannot absorb losses in all tail-risk scenarios, especially those related to Spains default."
Pouring cold water on the rally, Moodys pointed out that Cédulas constitute an aggregate 12% of Spanish banks funding, equivalent to 40% of Spanish GDP. "The capacity of either the government or the banking system to support Cédulas Hipotecarias has diminished in recent years," it said.
New mortgage laws could also put Spanish covered bonds under pressure. If borrowers are allowed to cancel bad debt and hand in their keys, their incentives to keep up regular mortgage payments could be eroded spelling trouble for covered bond investors.However, given the willingness of investors to get their hands on any assets they can seemingly despite the considerable risks remaining in Europe issuers will not be too worried. As the market continues to grind tighter, covered bonds will continue to provide them with a solid financing option.