The covered bond market broke new ground in 2005, extending out along the yield curve, reaching new issue sizes, and breaking the 1999 supply record. It did so through the opening of new markets, the arrival of new issuers and the creativity of established names. 2006 promises to be just as exciting. Neil Day reports.
Having come tantalisingly close to setting new records for issuance in 2003 and 2004, the jumbo covered bond market finally broke the previous high in 2005, pushing through 1999's Eu121.7bn to around Eu135bn towards year-end, according to HVB.
The manner in which the record was broken was also indicative of the developments that have been driving the market higher.
On November 9 Nationwide launched the first covered bond from a UK building society, a Eu2bn 10 year transaction led by Barclays Capital, Deutsche Bank and Dresdner Kleinwort Wasserstein.
The ways in which the issue borrowed techniques from structured finance, came from a relatively young sector, and marked a debut for the issuer were all representative of the deals that have pushed the market forward.
While supply from younger jurisdictions has flourished, Germany's jumbo Pfandbrief market remained within the Eu45bn-Eu50bn range of recent years, according to HVB, well down from the Eu103.8bn figure of 1999 when the country almost single-handedly propelled the sector to its previous high.
Like other newcomers, Nationwide was looking to share in the same benefits as other banks entering the market.
"We regard this as a very important transaction," Graham Beale, group finance director of Nationwide, told EuroWeek at the time. "We see the covered bond programme as very much supplementary to and an enhancement of our wholesale funding platform that will make it deeper and broader."
A broad array of new issuers are set to embrace covered bonds in 2006, promising an even higher total for the year. A survey of analysts by EuroWeek in December found not one expecting a drop in issuance and most forecasting supply of Eu145bn-Eu155bn.
One or two excluded new markets from their forecasts, while several included estimates for issuance under Italy's new covered bond framework and from Sweden's modernised mortgage bond market.
If anything, the market is set to surprise on the upside, with transactions possible from Portugal and Belgium. Observers have even raised the possibility of covered bonds from Turkey and the United States.
Not surprisingly, covered bond market participants are in a bullish state of mind.
"The covered bond market has had a banner year in 2006," says Ted Lord, global head of covered bonds at Barclays Capital in Frankfurt. "Volumes are up significantly and more countries are establishing legislation.
"With the jumbo covered bond market now approaching an annual volume close to 70% of the US agency market, it has come of age and continues to go from strength to strength."
Germany faces stern test
The jumbo market's biggest test last year, and perhaps in its 10 year history — which was celebrated in Germany in May — came in November when the troubles of Allgemeine HypothekenBank Rheinboden (AHBR) came to a head.
The bank had long been struggling to come to terms with misguided interest rate bets and real estate investments and its main shareholder, Beteiligungsgesellschaft der Gewerkschaften (BGAG), the trade union holding company, had put it up for sale.
But on October 25 FT Deutschland ran a story saying that the liquidation of AHBR could be imminent.
Despite the confidence that has grown up around the more than 200 year history of the Pfandbrief, the article sparked panic among holders of AHBR's bonds.
Within hours of the news emerging, market-making — long hailed as the safeguard of liquidity for jumbo Pfandbriefe — had ceased, and investors struggled to find bids for their holdings. Banks were too afraid of the mark to market losses they might face and credit lines to AHBR were put under close scrutiny — even though the same banks' covered bond analysts were declaring that its Pfandbriefe would stand the test of even a liquidation of the bank and the rating agencies were affirming AHBR's high Pfandbrief ratings.
This alarmed many investors. "It is disappointing," said Claus Tofte Nielsen, senior portfolio manager at Norges Bank Investment Management, a leading covered bond investor which is the investment arm of Norway's central bank in Oslo. "With all the improvements in legislation that they have been doing, this should be bankruptcy-remote, and yet despite this there is no market-making.
"If you believe in the law, in the worst case this should be considered now as an ABS, and it is trading 10bp wider than a triple-A RMBS. So far, the market's confidence in the Pfandbrief law has not been proven."
AHBR spreads had widened to as much as 30bp over mid-swaps. Its 2.5% September 2010 bonds moved from mid-swaps flat to the low to mid 20s over. Most recently, they were at 15bp over.
Sensing the long term damage that could be done to the jumbo Pfandbrief market's reputation, the leading market-makers shored up AHBR's bonds and by the end of the week were making an ad hoc market to investors.
By early December BGAG had found a buyer willing to take AHBR's debts off its hands at a price — US private equity fund Lone Star — and the threat to the jumbo Pfandbrief market had receded.
Indeed, despite the market's failings during the crisis, the spreads of other jumbos had held firm and confidence in the long established market — albeit under the new general Pfandbrief Act that had been introduced in July — returned quickly.
"We can all sleep comfortably, safe in the knowledge that there is not a problem for Pfandbrief investors," said Tim Skeet, managing director, financial institutions origination at ABN Amro in London. "Under the Pfandbrief Act it has all been anticipated and catered for, so if the worst comes to the worst, which is most unlikely, then the law as it stands will cover all the necessary points."
Spain beats all comers
The biggest part of jumbo supply in 2005 was from the Spanish cédulas market, which grew 47% to Eu55bn.
Volumes were boosted by new issuers. Banco Pastor launched its debut Eu1bn 10 year via ABN Amro, Barclays and Deutsche in late February and Banco Popular in mid-October issued an inaugural Eu2.5bn seven year trade via ABN Amro, DrKW, Goldman Sachs and SG CIB.
And repeat issuers came back for even more. According to HVB, the average supply from individual issuers increased from Eu3.11bn in 2004 to Eu4.62bn in 2005.
Supply continued to be driven by the growth in the underlying Spanish mortgage market. "What is the cédulas limit?" asked HVB's analysts in December. "We don't know! In the first nine months of 2005 compared to the same period for 2004, Santander's mortgage loan book increased by 16%, BBVA's by 22%, Banesto's by 27%, Banco Popular's by 26.7% and Banco Sabadell's by 22.3%."
This apparently irresistible trend resulted in the launch of the largest ever covered bond in the second last week of jumbo business in December.
The Eu5.4bn three tranche issue off the AyT Cédulas Cajas platform, led by Calyon, Deutsche, HSBC and HVB, was absorbed surprisingly easily. Despite being split into Eu2bn seven year floating, Eu2bn 10 year fixed and Eu1.4bn 17 year tranches, there had been fears that the impending year-end and other 10 year supply would sap demand.
"We were convinced that it would work, but were a little bit concerned about the timing," says Christian Reusch, co-head of syndicate at HVB in Munich. "However, it turned out to be a huge success for the issuer and investors, with more than Eu8bn of orders for the transaction and all three tranches tightening slightly in the aftermarket."
Issuers also overcame the difficulties that they have faced in getting the CNMV, the Spanish market regulator, to approve transactions in a timely manner. The EU Prospectus Directive eased the way for individual banks, while the arrangers of multi-cédulas issues came up with new ways to speed up execution.
Leaner and longer
At the beginning of the year Caja Madrid had opened the door to long dated issuance from fellow cédulas issuers with the first benchmark covered bond as far out as 20 years. The Eu2bn 20 year issue, led by Barclays, Caja Madrid, HSBC and Ixis CIB, was a hit with investors.
"At the time there were a few banks that were not too convinced the issue would go well," says Carlos Stilianopoulos, head of capital markets at Caja Madrid. "But there are always investors who are interested in triple-A names at the very long end of the curve, and that was particularly true in January.
"We issued Eu2bn but had demand for Eu6.3bn, so the deal was a massive success and encouraged quite a few other Spanish issuers to tap the 20 year sector as well."
Even Santander Central Hispano failed to rain on the Spanish fiesta for once. The bank completed a long and hard reinvention of itself in the cédulas market with a successful Eu4bn dual tranche issue via ABN Amro, Calyon, Citigroup and Santander in mid-September.
"It is important as a big issuer to be sensitive in the way that we approach the market," said a funding official at Santander in Madrid of the bank's new approach. "We saw clearly in June when we were talking to investors that our primary market execution and performance in the immediate secondary market was not as wished."
Benefits clearer in UK
Santander's UK subsidiary, Abbey National, surprised no one when it launched its inaugural covered bond in late May. The bank had been touted as a candidate for issuance as soon as HBOS had launched the first UK deal, but its sale to Santander had held back its entry into the market.
The execution of Abbey's debut proved as professional as those of its predecessors — Bradford & Bingley and Northern Rock as well as HBOS — even if market conditions were challenging, with covered bond supply heavy. The Eu2bn 10 year issue was led by Barclays, Citigroup and Deutsche, and priced in line with outstanding UK issues.
Chris Fielding, head of securitisation and treasury advisory group at Abbey in London, told EuroWeek he was satisfied with the result. "We always hoped that we would achieve a spread of 9bp-10bp over," he said after the issue was priced at the wide end of that range. "We are a new issuer coming with a debut issue and given the market conditions we think it is a very good trade."
In between Abbey's inaugural covered bond and Nationwide's in December the UK market received a regulatory fillip when the Financial Services Authority gave banks permission to press ahead with covered bond issuance by signalling a more relaxed and constructive approach to the market.
Although the FSA's previous guidance had not capped issuance, the regulator had appeared unsure about the instrument's effect on the security of deposit holders. Its letter in 2004 outlining its view on covered bonds had implied that covered bond issuance above a ratio of 4% of total assets might lead to an increase in a bank's individual capital requirement (ICR), the capital ratio it sets for every bank.
Under the new approach laid out in August, the 4% level remained a monitoring threshold, but a new 20% upper benchmark was introduced which the FSA said was "the level above which we would be likely to consider issuance as being sufficiently material to require an increase in most banks' ICR."
Furthermore, Paul Sharma, head of the FSA's prudential standards department, said that neither the 4% nor 20% thresholds were hard limits, and that the level at which a bank's ICR would be increased would be set on a case by case basis.
New markets open up
The UK's structured covered bonds were also winning admirers among banks in continental Europe.
ABN Amro Bank borrowed heavily from UK structures for its debut, a Eu2bn 10 year issue that was the first true Dutch covered bond. Led by ABN Amro, Ixis and WestLB, the triple-A transaction was priced at 7bp over mid-swaps, just wide of HBOS paper.
Evertjan Manuels, vice president of group asset liability management at ABN Amro in Amsterdam, said the bank had achieved all its goals with its first covered bond, particularly with regard to pricing.
"From the start we were aiming to position ourselves next to HBOS because of the 20% risk weighting and because the structure and cover pool of the other UK issuers are less conservative than ours," said Manuels. "On the roadshow it was clear that all the investors were looking at our covered bond in the same way."
The same week Sampo Housing Loan Bank launched the first euro denominated jumbo covered bond from the Nordic region, a blowout Eu1bn five year issue led by Barclays, DrKW, JP Morgan and Sampo. The bond delivered the issuer competitive funding of 1bp through mid-swaps after a Eu5.7bn book was built in less than two hours.
"I was expecting a good result, but not that good," said Martti Porkka, head of group treasury and funding at Sampo Group in Helsinki. "The pricing was very much in line with the levels we were expecting because the market was getting better during the roadshow.
"However, the speed and size of execution was surprising. We were oversubscribed in something like three minutes."
Italian covered bond issuance got off to a poor start in March, when Cassa Depositi e Prestiti's (CDP) debut Eu1bn issue was launched late, was smaller than hoped for and was priced too aggressively before guidance was revised.
However, CDP restored its reputation in mid-October with a Eu3bn seven year trade via Barclays, Nomura and UniCredit Banca Mobiliare (in co-operation with HVB). Textbook execution by the state owned bank, which issues covered bonds under a law specific to CDP, left market participants in a much better mood as they wait for issuance by private banks under Italy's new general covered bond framework this year.
Dollars on the increase
Issuers from established covered bond markets, meanwhile, were taking their products to new markets, particularly dollars. In one week in October, for example, three issuers launched large dollar trades.
Bayerische Landesbank issued a $500m long three year issue via ABN Amro and JP Morgan; Landesbank Baden-Württemberg a $500m three year via ABN Amro, HSBC and LBBW; and Compagnie de Financement Foncier a $1.25bn long three year via ABN Amro, DrKW and UBS.
The deals followed a $1bn long three year from Hypothekenbank in Essen two weeks earlier, which had been led by ABN Amro, Goldman Sachs and HSBC, with Commerzbank a joint lead.
"The dollar market is clearly opening up for covered bond issuers," says Christof Jütten, responsible for covered bond origination at Goldman Sachs in London, "and it can prove very competitive for them.
"If the bid for the currency continues then the investor base for covered bonds that develops in dollars could become as important as in euros."
While most trades were in Eurobond format, Essenhyp joined the only covered bond issuer to have previously made the dollar market a priority, Depfa, by courting US investors through a RegS/144A deal in early December. Bear Stearns and DrKW reported placement of 34% of the $1bn five year trade to US accounts.