Its a good job the Portuguese travel so well. Issuers of obrigaçoes hipotecárias have probably had to market themselves more intensively than any other new entrants to the global covered bond market over the last decade. When Caixa Geral de Depósitos (CGD) opened the market with its Eu2bn 10 year debut deal in November 2006, the banks indefatigable treasury team marketed the new issue to more than 100 institutions in no fewer than 16 cities in Europe and Asia.
That unusually extended marketing push was driven partly because Portugal arrived late at the European covered bond party, eventually passing its covered bond law in March 2006 after at least five years of painstaking legislative preparation. It was also driven partly because Portugal has a tiny domestic institutional investor base, meaning that no benchmark covered bond from the country could hope to succeed in the absence of very solid support from foreign investors.
Since CGDs successful icebreaker, Portugals close-knit club of covered bond issuers has, if anything, needed to step up rather than relax its international marketing of obrigaçoes hipotecárias. One obvious reason for that has been the savage re-pricing that has taken place in the European covered bond market over the last six months. Another reason can be summed up in a single word: Spain.
Although their languages are different, the geographical proximity of the two countries has inevitably meant that they have tended to be regarded by international investors as belonging to a single and very homogenous economic block. So too have their housing markets, which has become increasingly galling for Portuguese mortgage lenders. The consequence, as Spains property market has lurched from one crisis to another, has been that disabusing investors of that erroneous assumption is a more pressing priority for Portuguese banks than ever before.
That much is clear enough from the material handed by Portuguese covered bond issuers to investors in their roadshows. For example, when BPI took to the road in May, its investor presentation contained a detailed comparison of the two Iberian countries, reminding investors that prices in Spains housing market have been on the slide since 2003, following years of precarious overheating.
Portugal, said the BPI presentation, was quite different (see graph). "Having avoided the extreme growth in property prices seen in Spain, the Portuguese housing market benefits from greater stability and resistance to market shocks," it explained. "Moreover, the Portuguese construction sector has already proved it is able to successfully weather less favourable conditions. As economic conditions in Portugal stabilise and continue to strengthen, the outlook for the Portuguese market is mildly positive. Since there is no residential bubble on the verge of deflating and the sector has been under correction for the past decade, it is unlikely that the housing market will deteriorate even if the Portuguese economy decelerates in tandem with major EU economies."
"In comparison to Spain," BPI added, "the strength of the Portuguese mortgage market is highlighted by a growth rate of roughly 10% annually over the past few years despite low GDP growth, high unemployment and downbeat consumer confidence. At the same time, the Spanish mortgage market grew at 20% annually in extremely favourable conditions."
The false impression among some international investors that Portugal and Spain are economic Siamese twins is especially perverse, say some bankers, because when Spain has boomed in recent years, Portugal has not been a conspicuous beneficiary. "Curiously, Portugal has historically been quite isolated from Spain from an economic standpoint," says Demetrio Salorio, head of debt capital markets at Société Générale in London. "Economically, Spain and Portugal are not as interconnected as two neighbours might be."
Portugal too feels the pinch
When Portugals obrigaçoes hipotecárias belatedly arrived on the European covered bond scene in November 2006, the distinction between the two markets appeared to be fully understood by international investors. "When the Portuguese market opened, investors recognised that its housing market was very different to Spains and that its law was much more solid," says Wally Höfer-Neder, head of European covered bond origination at Deutsche Bank in Frankfurt.
Justifiably so, say others. "Portugal worked for about six years on its covered bond law, which meant that it was able to pick the best practice of legislation in all the other European markets," says Chris Gahr, origination director for financial institutions at UniCredit Markets & Investment Banking in Munich.
In the formative stages of the market for obrigaçoes hipotecárias, the distinction between Portugal and other covered bond markets also appeared to be reflected fairly in the pricing. CGDs curtain-raiser via Barclays Capital, CaixaIB, Nomura and Société Générale, for example, was priced at 4bp over mid-swaps, which compared with secondary market levels for 10 year cédulas hipotecarias of 7bp.
When Banco Comercial Portuguès (Millennium BCP) took its bow in the market, with the launch of Portugals second covered bond in June 2007, it went one step better. Following a roadshow almost as exhaustive as CGDs the previous year, BCPs Eu1.5bn 10 year deal led by Barclays Capital, Deutsche, Société Générale and Millennium BCP generated demand of Eu3.8bn, allowing for pricing to be revised from 4bp to 3.5bp over mid-swaps.
Wind the clock forward nearly a year and market conditions had become unrecognisable from those in which BCP had launched its first deal.
In April 2008, its Eu1bn two year bond led by Barclays Capital, Deutsche, Millennium BCP and Natixis was priced at 40bp over mid-swaps. The following month, when Banco Santander Totta launched its debut covered bond, a Eu1bn three year transaction via BNP Paribas, Morgan Stanley and UniCredit, the issue was priced at the mid-point of its guidance range of mid-swaps plus 40bp-42bp.
"Over the last year there has been a clear shift in the way investors see this product," says Diogo Lacerda, head of debt capital markets at Millenniums investment banking division in Lisbon. "They no longer see it as an interest rate product similar to supranational or even public debt. They now regard it as a credit product."
That, of course, is not a dilemma that is peculiar to Portuguese issuers, with borrowers across all European covered bond markets feeling the pinch much more acutely than anybody would have anticipated 12 months ago. As Dresdner Kleinwort succinctly put in it its Pfandbrief Weekly bulletin in early September, the European market is now moving "from bad to worse".
Caixa gets its upgrade
For Portugal, the precipitous collapse in investor confidence in the European covered bond market is especially frustrating for a host of reasons.
Foremost among those is Decreto-Lei no. 59/2006 of March 20 2006, to give the Portuguese law on covered bonds its formal name. Allowing for the issuance of mortgage backed bonds and issues collateralised against public sector loans, Portugals law is generally regarded by bankers and rating agencies as being among the most robust in Europe. "Clearly the main strength of the Portuguese law is that it is based on the strongest parts of the laws governing German Pfandbriefe and French obligations fonciéres," says Ralf Grossmann, head of covered bond origination at Société Générale in Frankfurt. "That means that under Portuguese law there is very clear segregation of assets, well defined post-insolvency procedures and a relatively high overcollateralisation requirement of 5.3% which has to be maintained at all times on a net present value basis. There are also very clear stress scenarios for asset and liability management."
Another reason why ballooning spreads in the covered bond market are frustrating for Portugals covered bond issuers is that in marked contrast to several European banking industries, Portugals financial services sector is in reasonably good shape. True, competition in the industry has intensified in recent years, and loan impairments have been edging up at several banks. But Portugals banking sector gave the US subprime mortgage market a wide berth and rating agencies recent comments on the industry have generally been positive.
Indeed, in the case of Portugals largest bank, Caixa Geral de Depósitos, there has even been a recent upgrade, which kicks against the trend in todays beleaguered European banking market. In August, Standard & Poors upgraded CGD to AA- from A+ with a stable outlook, commenting that "the upgrade integrates CGDs enhanced financial profile, with better core profitability and asset quality metrics than in the past, as well as proven state support."
Filomena Oliveira, senior general manager at CGDs Lisbon headquarters, says that the S&P upgrade hardly came as a surprise. "For a long time, the upgrade is something we had been fighting for," she says. "For several years S&P kept us at single-A. That meant that we had a split rating, which made it difficult for us to enter certain markets. After the meetings we had in June, I was confident that we would be upgraded by S&P." In part at least, Oliveira says that the upgrade was an acknowledgement of the value of CGDs retail franchise and of the loyalty of its customer base, key considerations in a market environment in which liquidity in the form of deposits has become a precious commodity.
Oliveira says that she believes the S&P upgrade will eventually have a beneficial impact on CGDs funding costs, but that in todays tumultuous market, in which there is such a clear investor preference for the short end of the curve, those benefits are hard to assess. "We have seen more demand from investors for our short term paper, which has allowed us to issue EuroCP and US CP at levels that are even more aggressive than we were able to achieve before the crisis," says Oliveira. "In medium and longer dated maturities we have seen no immediate impact on our pricing because we havent issued anything in the primary market and there have been no flows in the secondary market."
"Over the longer term," Oliveira adds, "we think this upgrade will reduce our funding levels, but we also think it will help us to enter some new markets. In the US weve only been present in the CP market, and although we have some investors in Asia mainly in Japan we think we will be able to penetrate a deeper investor base there."
Punching above its weight
It is not just CGD that is regarded as an improving credit. "Following a period of consolidation, it would appear that the Portuguese banks are on a good road to recovery," says Tim Skeet, managing director and head of covered bonds at Merrill Lynch in London.
Other rating agencies support this view. In its latest round-up of the Portuguese banking industry, Fitch comments that "given that a favourable economic environment is expected to continue, a substantial deterioration in asset quality seems unlikely, although some retail borrowers are being affected by higher interest rates. Furthermore, all the leading Portuguese banks should be cushioned from any deterioration by their ample loan impairment reserves. Capital ratios should continue to be at least adequate, supported by good internal capital generation. Fitch welcomes the capital increases already announced this year. In anticipation of the implementation of Basle II in 2008, the banks have been enhancing their risk management systems and reviewing their risk profiles and economic capital requirements."
Overall, Fitch reports that it does not expect any significant changes in its ratings for major Portuguese banks at present. "The leading Portuguese banks have continued to perform soundly in recent years, despite the difficult operating environment," Fitch notes. "There has, therefore, been considerable stability in the ratings."
Aside from the robustness of the industry and the stability of ratings, there are other structural reasons why analysts believe that Portugals covered bonds should certainly trade well inside Spanish cédulas and possibly close the gap with other core European markets. One of those is that the market remains small and self-contained, accounting in July for just 1.88% of the EuroMTS Covered Bond Aggregate Index, although in the first quarter of the year Portugal punched above this weight, with a 6% share of total European supply.
Portugals total share of the European covered bond market will remain modest. "Taking into account the volume of outstanding mortgage loans of the five biggest Portuguese banks of Eu96bn as of December 31 2007, one can roughly estimate the Portuguese covered bond market potential," says Deutsche Bank in a recent comparative analysis of European covered bonds. "If one assumes a growth rate of only 5%, the medium term market potential easily adds up to Eu35bn-Eu40bn." That would represent approximately a four-fold increase on the total outstanding today, although as Deutsches report points out, "against the backdrop of a jumbo covered bond market amounting to Eu850bn as of December 31, 2007, Portugal will... in the future play only a limited role. Nevertheless, the mix of a strong legal framework and the fact that Portugal is not a triple-A rated country, offers investors access to triple-A Portuguese assets with some spread pick-up."
Double digit growth in mortgages
Bankers say that the relatively modest size of the market is a clear advantage for Portugal, and that the maintenance of that scarcity value should underpin continued strong support for obrigaçoes. "The fact that there is a strong legal framework in conjunction with a limited pool of issuers with relatively low total funding needs is something that investors certainly appreciate," says Derry Hubbard, head of covered bond marketing and execution at BNP Paribas in London.
Allied to its relatively small size, another important box that Portugals covered bond issuers have ticked is an investor-friendly approach to the market that contrasts with the new issuance strategies that were espoused by some Spanish borrowers in the early days of the cédulas market. "Issuers in the Portuguese covered bond market have been flexible on market approach and maturity and have generally been prepared to leave something on the table for investors, which has been important in helping them to maintain their access to the market deep into the crisis," says Hubbard.
The modest size of the Portuguese covered bond market, say bankers, is not just a by-product of the relatively small size of the Portuguese economy. "The expansion of the Spanish property market meant that Spain became very dependent on external funding to support the growth of the market," says Société Générales Grossmann. "That hasnt been the case in Portugal, where banks have used covered bonds largely as a means of diversifying their investor bases. So Portuguese banks have been under much less pressure to use the covered bond market than their counterparts in Spain."
That is not to say that the covered bond market does not matter to Portugals banks. Quite the opposite. "In Portugal the only asset class that has grown at a double digit rate in recent years has been mortgages," says Lacerda at Millennium. "That is because there is not an efficient rental market in Portugal so people tend to buy their houses instead. Also, there were was a very significant drop in Portuguese inflation and interest rates after we joined the euro, so home loans became more accessible to a bigger percentage of the Portuguese population," he adds. "The proportion of banks assets that are in mortgages is higher than in the 1990s, and as covered bonds allow us to issue in longer maturities than the RMBS market, we see them as an important strategic funding tool."
"The Portuguese banks do have the benefit of relatively large deposit bases," adds UniCredits Gahr. "But they still see covered bonds as being of strategic importance as funding tools, and they have worked hard to improve the profile of their product and of the Portuguese legislation."
Merrill Lynchs Skeet agrees. "Clear communication between issuers is a hallmark of a stable market, and the Portuguese banks have been well-disciplined and ordered about the way they approach the market," he says.
Wanted: Bigger domestic bid
In promoting their product, however, some bankers say that Portugals issuers have one hand tied behind their backs because of the very low domestic bid for their bonds. "German investors are still the main takers of Portuguese covered bonds, although there has also been some strong demand from areas like Scandinavia and the Benelux countries," says Gahr at UniCredit. "A clear problem for the Portuguese banks is that there is almost an absence of a domestic bid."
That much has been evident from the distribution of the landmark transactions in the markets short history.
In CGDs first benchmark, for instance, only 7% was taken up by Iberia-based investors, and when it returned to the market in June 2007, this share had fallen to just 4%, with investors from France (28%) and Scandinavia (22%) anchoring demand for the transaction led by BNP Paribas, CaixaIB, Citigroup and UniCredit. More recently, when Millennium BCP issued its Eu1bn two year benchmark in April 2008, less than 1% went to Portugal, with more than a quarter of the allocation accounted for by Danish investors, and Germany taking a further 19.7%.
Other issuers confirm the weakness of local demand for Portuguese covered bonds. "I dont think that under any circumstances domestic demand would be enough to support a jumbo transaction," says Antonio Lobo Ferreira, senior manager at BPI in Lisbon. "The most an issuer could expect to place in Portugal would be about 10%."
In part, says Ferreira, that is a reflection of the spreads available in other areas of the market. "Spreads tend to move in parallel," he says, "and I have the impression that when there is so much focus at the short end of the curve, investors would rather buy banks senior unsecured notes that still pay a big premium over covered bonds."
At Millennium, however, Lacerda says that although domestic participation is low, it is on the rise. And recent distribution statistics support the view that local investors may be becoming more important players at the primary level, perhaps attracted by new issue spreads as wide as barn doors. In July, for example, Portuguese investors accounted for 6% of allocation when Banco Espirito Santo launched its second covered bond, a Eu1.25bn two year transaction led by BES, HSBC, JP Morgan and LBBW, priced in line with guidance at 45bp over swaps.
Some say that over the longer term, Portugals dependence on overseas investors need not matter. "From the outset, this asset class benefited from substantial international demand for the scarcity value and diversification it provided," says Salorio at Société Générale. "If spreads are suffering it is a reflection of the transformation were seeing in the covered bond market as a whole, not of investors favouring their home market over other asset classes. Although German spreads have benefited from the strength of domestic demand, I cant think of another European market where the same has happened." In other words, this suggests, covered bond investors within the eurozone are becoming more agnostic about the products they buy.
Issue now or pay more tomorrow
Others say that in the context of such a brutal downturn in the European covered bond market, that dependence is or should be a concern. "Portuguese issuers have had to rely on the strong buyers of covered bonds in Germany, Scandinavia and the Benelux region," says Höfer-Neder at Deutsche Bank. "If they cant convince those investors to continue buying into their product, they will have a big problem."
Concerns over the thinness of the domestic bid, she says, is one that issuers in neighbouring Spain have recognised and have been tackling.
It was notable that when the Spanish cédulas market re-opened in early May, it was the beneficiary of increased support from the local investor base. In the case of BankInters Eu1.5bn two year transaction, for example, Spanish investors took 37% of the issue, while almost 57% of Bancajas debut Eu1bn two year deal was placed in Spain. Strong local demand for these transactions, say bankers, sent out an encouraging message to overseas investors.
Certainly, overseas investors are demanding steep premiums for Portuguese covered bonds, just as they are for most new issues in todays battered market. In February, for example, CGD balked at the price it would have needed to pay to access the market with a planned benchmark. But bankers and issuers say that in the current market, assessing what would represent fair value for Portugal versus Spain is more of an imprecise art than a science.
"Our pricing today is better than in the Spanish market, but not by much," says Oliveira at CGD. "At the moment it is difficult to price a Portuguese deal at below 40bp over swaps, which I think is an incredibly high level compared to what we were seeing 18 months ago. Our perception is that in the foreseeable future there will not be a return to the pricing levels we were seeing before the crisis. Although we think that 40-something is very high, we have to recognise that that is the market price and that investors are still demanding extremely high premiums relative to the secondary market. The problem for us is that if we dont issue now, it is possible that with liquidity remaining low we may have to pay more in the future."
Others agree that in present market conditions it is difficult to formulate funding plans and almost pointless attempting to draw up issuance schedules. "Execution risk at the moment is very high so much so that windows of opportunity sometimes only stay open for a morning or an afternoon," says Lacerda at Millennium. "We think that based on the volume of our mortgage origination, we should be able to print one or two benchmark bonds a year."
Bankers sympathise, but say that over the longer term the fact that Portuguese banks have established well-respected issuance programmes augurs well. "The key point is that most of the leading Portuguese banks now have an important new funding tool in their hands," says UniCredits Gahr. "For the time being, some Portuguese issuers may continue to shy away from public issuance because they are very reluctant to use up their precious cover pools for very short maturities at very high spreads. So in the short to medium term I expect to see more private placement issuance."
Optimism for public sector bonds
Expanding the diversity of the product might help to re-open the market for benchmark issuance of obrigaçoes. The other string to the Portuguese markets bow public sector issuance has yet to be tested in a meaningful way. The law of March 2006 paved the way for the issuance of obrigaçoes sobre o sector público (OSP), Portugals equivalent of German öffentliche Pfandbriefe, where public sector loans to European Union entities or loans guaranteed by the same public sector bodies are eligible as cover assets.
BPI has already set up a Eu2bn public sector issuance programme, but has so far only issued one Eu150m private placement of OSPs. "Our public sector portfolio is relatively small, accounting for about Eu1bn of our total Eu29bn loan book," says Ferreira at BPI. "That means that we dont have a big enough portfolio to sustain a jumbo public sector transaction, so we will continue to concentrate on the private placement market based on market opportunities."
With the other Portuguese private sector banks also constrained by the modest size of their public sector portfolios, the only bank that will be able to offer benchmark OSPs is the government-owned CGD, which is now readying a debut public sector transaction backed largely by loans to domestic municipal borrowers. Moodys and Fitch were in Lisbon earlier this month completing their due diligence on the transaction, and CaixaIB has already been mandated as the lead manager.
"We havent decided on a maturity yet, which will depend on the feedback we receive from investors," says Oliveira. "But we would like to do something in the medium range of the yield curve because we believe that the product is a good way of extending our overall maturity profile."
Oliveira says that she is also hopeful that a successful public sector transaction will help to re-open the market for mortgage backed obrigaçoes. "I am very optimistic that the scarcity of public sector bonds will ensure that the deal is a success, and if it is, perhaps it will allow us to take advantage of improved investor sentiment by issuing a mortgage backed transaction."
Bankers share Oliveiras confidence in the prospects for CGDs public sector debut. "There is a lack of supply in the European public sector covered bond market," says Salorio at Société Générale, adding that if recent evidence is anything to go by, the bonds scarcity appeal should underpin healthy demand and secondary market performance. "Some of the recent public sector bonds in the German market have been very well received by investors, and we strongly believe that Portuguese public sector obrigaçoes can benefit from the same demand."
Grossmann agrees, adding that the quality of the CGD public sector bonds will be extremely high. "The business model underlying the CGD issuance is financing local authority lending in Portugal, rather than flying round the world trying to grab public sector assets wherever possible as collateral for regular jumbo issuance," he says. "It is a very dedicated and very focused business approach, which will ensure that the scarcity value remains in place. We wont see more than one benchmark a year from CGD."
BPI hopeful of 2009 benchmark
Perhaps. But in sum, in spite of the clear relative strengths of Portuguese covered bonds, issuers room for manoeuvre in response to widening spreads appears to be limited. "When the crisis began, investors were still quite keen on meeting issuers and listening to their credit stories," says Höfer-Neder. "But today, they are so fed up with the spread widening they have seen on all their holdings that it is now extremely difficult for borrowers even to arrange meetings with investors. At the moment, they are not even interested in soft sounding." Small wonder, against that bleak backdrop, that when Santander Totta launched its debut bond in May, it chose to do so unusually without heavy pre-marketing.
In the meantime, Portuguese issuers remain stoical about the turmoil in the covered bond market and its effect on their spreads. At BPI, Ferreira says that he remains hopeful of placing a benchmark transaction in 2009. "Of course we would prefer to do something longer than two years but if thats where investor demand is, then we will do a two year benchmark," he says. "It is a frustrating market at the moment but deals have been done by Portuguese issuers and we have been able to maintain our access to the market, which is good. At a time when borrowers in some other jurisdictions have been shut out of the market, it has not all been bad news for Portuguese covered bonds."