The cosy worlds of bank debt investors were shattered by the financial crisis and not just by defaults and the threat of default. Long-held assumptions and practices have had to be ditched, none more so than the belief that senior unsecured debt would be held sacrosanct by regulators.
That has allowed the dual-recourse collateralised and on-balance sheet nature of the covered bond product to gain ground, even to the point where today the worry is not about the potential size of the market outside of its historical core jurisdictions, but whether senior unsecured can ever recover.
The start of issuance year 2011 provides the evidence. By the end of February, European banks had raised Eu140bn of long-term funding and half of it came from covered bonds, up from a historical average for the product of around one third.
"There has been a significant change in the market because this is the first time in history that volumes of covered bonds are broadly in line with senior unsecured issuance," says Siddharth Prasad, head of EMEA FIG global finance at Nomura in London.
Throw in the fact that Yankee issuance of senior unsecured has been stronger than usual and the situation back in Europe is even starker. Senior unsecured is withering. But why?
Blame it on bail-ins, say FIG debt bankers. The idea that banks can be recapitalised, on a going-concern basis, by haircutting senior unsecured debt holders was first mooted in 2010 and gradually the concept made it into ever more regulatory discourse.
But the concept exploded into the consciousness of European debt investors in January this year. That was when the European Commission said that bail-ins would be part of future regulatory regimes, beginning in 2013.
The details were and remain hazy but investors knew what they had to do: sell senior. Spreads blew out.
"It caused a knee-jerk reaction," says Mauricio Noé, head of senior and covered funding at Deutsche Bank in London. "When the paper was released in January the whole senior market blew out." Covered bonds reacted badly, too, he, says, as the market immediately came to the conclusion that if senior was going to take a beating, covered bond supply would have to increase putting pressure on spreads there, too.
But bail-ins are still a matter for debate.
Even though some countries have gone ahead and included the feature in recent bank resolution legislation including in Germany, Ireland and Denmark, the latter already implementing a bail-in, albeit simultaneously with an old-fashioned bankruptcy, that of Amagerbanken in February bankers continue to debate the details.
Noé says that much of the reaction is overblown senior debt is not, in most jurisdictions yet subject to bail-in, and the Basel plans dont envisage already-issued debt to become so.
The Basel paper says that bail-ins will not be applied retrospectively in other words, existing issuance will be grandfathered. But a comprehensive regime is on the way, say bankers.
"We think that the way the debate is going to evolve is via a comprehensive statutory effort legislation has already been introduced in Ireland, Denmark and Germany (and we think the UK Banking Act will be amended similarly) and all these regimes allow for bank debt to be bailed-in," says Prasad.
"We see several possible scenarios. First, a comprehensive regime that includes existing debt. Second, a comprehensive regime with grandfathering provisions that carve out pre-2013 issuance. And third, a more targeted approach as being discussed at the EU level, to create a new class of senior bail-in debt. Banking regulators are trying to make sure that bank instruments can absorb losses across the liability structure, ahead of taxpayers."
He warns that senior unsecured ratings will take a hammering if bail-ins are implemented, much as subordinated debt was downgraded when the rating agencies stopped assuming that sovereigns would automatically support financial institutions.
"Depending on the final shape of the resolution regime, it could pressure the joint default analysis (JDA) leading to a whole section of issuers being downgraded with the possibility of becoming non-eligible for many fund managers current mandates," he says.
Even as senior debt has struggled against the weight of new regulation, covered bonds have been given fresh impetus. The Basel III liquidity regime is the driving force, says Prasad. It has two main provisions, and they are impacting on supply and demand and boosting both.
First, supply. Basel calls for banks to meet a net stable funding requirement (NSFR) essentially a demand for liabilities to better match assets which means banks will need to lengthen the duration of liabilities. And where can banks find duration in the wholesale funding markets? Covered bonds.
"The NSFR means that issuers have to better match the maturities of their liabilities to assets and since duration is currently most efficiently provided by the covered space, supply is biased towards this market," explains Prasad.
The second element of Basels new liquidity regime will similarly act on demand for covered bonds. The liquidity coverage ratio (LCR) is a new measure of a banks ability to withstand a crisis in which funding markets are closed and deposits are leaking out similar to that of 2007/9.
Banks must maintain a pool of liquid assets that can be drawn down on in a crisis situation and that pool must not only be bigger than in the past, but must contain assets of much higher quality. But thanks to a continental Europe that is evangelical about covered bonds no defaults, ever, not even in the crisis they too can be held in liquidity buffers even as UK regulators rule them out.
"The friction cost associated with liquidity requirements are clearly impacting profitability, return on equity and banks ability to lend to the real economy," says Prasad. "UK banks in particular are pushing for greater flexibility from regulators to invest in covered bonds as part of their liquidity buffers. If just one third of banks liquid assets are available to be invested in covered bonds then that creates a major long term investor base for the product."
However, the LCR will not be all one-way traffic. As Noé points out: it depends where a bank is based. "We have very high hopes of the bank investor base for the product, subject to it being liquid enough for regulators," he says. "But theres an economic aspect too. Covered bonds will be subject to a 15% haircut so, while they may be valuable when compared with Bunds, if you are an Italian bank then they might not be so attractive if you are comfortable with BTPs."
Covered bonds are also attracting another class of investor new to the product one which would have previously been core to senior unsecured debt helping to boost demand for the product, and what bankers say is a big factor in covered bonds growth in 2011.
Traditional credit investors used to shun covered bonds as too expensive covered was after all positioned, pre-crisis, as a risk-free, rates product.
But with spreads for all asset classes in non-core Europe blowing wider, covered bonds are now firmly on the menu.
Jurisdictions in which covered bonds yield 100bp over mid-swaps or more have become favourites of credit investors, say bankers, and these are the investors that have helped covered bond books expand to contain several hundred investors.
So, factors boosting both supply and demand have driven the momentum behind covered bond sales this year. Add in a more prosaic factor that many peripheral European bank issuers have no other option for market access and it is unsurprising that covered bond issuance has run so high.
But that still begs two questions: what brakes are there on issuance and can senior debt again provide an alternative?
Blessing or curse?
"There are plenty of brakes on covered bond supply," says Noé. The first might seem obvious that issuers must have not just enough collateral but also the right kind of collateral but for many banks it does provide a meaningful limit on issuance. High quality mortgages are the only asset allowed in most cover pools.
But balance sheet capacity works in other ways, too. Some countries impose strict limits on covered bond liabilities because an over-reliance will theoretically reduce the credit quality of the unencumbered portion of a balance sheet.
"There is an argument that a potential spiralling effect exists, whereby growing covered bond funding could gradually crowd out appetite for senior unsecured debt," says Fitch Ratings. "Certainly, increased issuance of secured funding in a troubled bank may become more a curse than a choice for treasurers seeking investors for unsecured issues."
Still, figures show that few banks are close to hitting their issuance ceilings.
But while balance sheet constraints might not, at least for some while, act as a brake, the cost of the over-collateralisation feature of covered bonds could be more important.
Deutsche Banks Noé thinks that minimum OC levels throw up balance sheet efficiency problems for banks because the NSFR rules require banks to fund the full OC level with long term funding.
"Remember that from a perspective of collateral efficiency, covered bonds dont always make sense. A lot of the market hasnt yet appreciated that point including many issuers," he says.
"If you compare the necessary credit enhancement on a prime UK RMBS where credit enhancement is around 15% to the over-collateralisation of a UK covered bond at between 20%-30% on the same pool of mortgages then covered bonds are not so efficient."
And, for banks in peripheral European jurisdictions hit by sovereign debt restructuring concerns, economics also play a part in putting the brake on covered bond issuance. Just because covered bonds are the cheapest form of long term funding, or even because they are the only instrument that a bank could realistically issue, doesnt mean that banks will issue.
"Spreads are still elevated and banks just cannot keep funding at these levels," says Noé. The European Central Bank will have to continue to provide liquidity, he says.
Geeing up the workhorse
So what then is the future of senior debt? "Covered bonds have a bright future," says Prasad. "But while most issuers arent currently at or near capacity from a balance sheet perspective the fact is that regulators will be worried about issuers cherry-picking assets for their covered bond pool. At some stage it could become a problem and the senior unsecured asset class has to be rehabilitated."
He says that two developments in particular will underpin confidence in senior debt. "The first is national finishes which are higher than the Basel regime, including Coco debt, and the second is senior bail-in debt. Both these provide increased layers of protection for senior creditors."
The higher bank capital requirements demanded by Basel III and the enthusiasm of national regulators to augment those levels for systemically important financial institutions (Sifis) provide a buttress for senior, unsecured credit quality. A layer of contingent convertible capital on top will add even more safety for bondholders. And if regulators then create a separate class of senior bail-inable debt a two-tier senior market then investors could have an instrument with an even stronger risk profile.
Noé, too, thinks that senior unsecured debt has a bright future. Banks will still have to issue senior. "It will remain the workhorse of bank funding," he says. "Dont forget that other forms of funding, such as MTN private placements are primarily in senior unsecured.
"After all, if as an investor you like a bank then why would you not buy the asset yielding more the senior rather than the covered? Investors are already taking a more matrix style approach to investing theyre looking across financial institutions more and looking at every instrument in the capital structure."