Covered bonds have provided cheap and simple funding for 200 years, but enormous investor appetite for yield and long bond duration has fuelled exponential demand in the last five years, nudging the market past €1700bn.
What sets covered bonds apart is that they are collateralised by an earmarked asset pool on the balance sheet of the issuer. The asset pool will usually be mortgages, residential-mortgage backed securities, public assets, and ship loans.
The percentage of the total covered bond primary issuance backed by public sector assets has declined every year since 1996, from around 97 per cent of the new issue market in 1996 to around 25-30 per cent today. But mortgage-backed business has boomed. Ship loans are also a growth sector, led by German HSH Nordbank, and several captives are beginning to investigate the potential of car loan collateral.
For banks, mortgage loans have always been a mass-market product used to attract customers for subsequent cross selling of higher-margin products. Mortgage margins are fairly thin, so the refinancing of the mortgage book has a major part to play in ensuring profitability and in boosting a bank’s market share.
Hungry for yield
For investors, covered bonds offer strong asset/liability matching and a preferential claim on collateral assets in the event of issuer default, taking precedence even ahead of the tax authorities and obligations to employees.
Investors are hungry for yield, and increasingly appreciate the desirability of asset diversification. Pension schemes in particular are looking for yield pick-up, and long-dated covered bonds provide access to durations that better match their liabilities and that are not available through many other instruments.
“In the pension market, demand has been driven by regulation and liability matching,” says Mauricio Noe, managing director at ABN Amro. “There are not enough assets at the long end of the curve, but there’s a caveat to that. These investors won’t buy at any price and may prefer to use shorter-dated bonds, together with swaps to manage any mismatch.
“It is the banks that are the biggest buyers at the long-end, which is counter intuitive, but they are after getting a positive carry on their funding and therefore are attracted by the bigger spreads.”
For money market funds and insurance companies, high credit rating and stability head the wish-list, while liquidity is particularly coveted by corporates and bank treasury accounts looking for discretion and the facility to chop and change positions without attracting attention.
Almost all covered bonds are triple-A rated. “Lower rated bonds are in demand,” adds Mr Noe. “Many banks are driven by a more irrational motivation to issue AAA-rated bonds, but this may change going forward.”
The huge success and growth of German Pfandbriefe has prompted countries across Europe to introduce similar arrangements in recent years. Covered bonds are issued in France (Obligations foncières), Spain (Cedulas), Ireland (Asset Covered Security), Finland (Kiinteistovakuudellinen or Julkisyhteisovakuudellinen), Denmark (Realkredit-obligationer), Norway (Saerskilt Sikrete Obligasjoner) and Luxembourg (Lettres de Gage). Sweden followed in 2004 with Sakerstallda Obligationer, and Italy, with a residential mortgage market worth €537bn, began the legislative process for its Obbligazioni Bancarir Garantite last year.
Guiding principles
Hungary, Turkey and Portugal are also on the verge of enacting covered bond law, with inaugural deals expected this year. However, certain regions, notably Australia, are unable to issue covered bonds as long as local consumer protection for bank depositors remains in place.
The regimes introduced have adopted the three guiding principles that have made Pfandbriefe so successful. Firstly, the secured debt issues are covered by high quality assets; secondly, the management of the cover pools is supervised; and thirdly, holders are first in the queue should bankruptcy proceedings be initiated.
Although each European framework is guided by identical principles, schemes differ from country to country. The eligibility criteria for cover assets varies in regard to geographical origins, and minimum loan-to-value criteria, as well as the requirement whether to separate mortgage and public-sector mortgage pools, and the nature of the preferential claim.
For instance, practice in Finland and Luxembourg is for 60 per cent loan to value ratios for both residential mortgage loans and commercial assets, while at the other extreme, Spain stipulates 80 and 70 per cent respectively while Italy and Denmark require 80 per cent for residential mortgages while Sweden and Ireland look for 75 per cent.
The arrangements in Spain are the biggest departure from the German model. Any Spanish bank or savings institution may issue Cedulas secured solely by mortgage loans on domestic properties, but it is less demonstrable under Spanish law than under Pfandbriefe that investors would be able to lay their hands on their assets in the event of issuer insolvency.
Pooling mortgages
The Spanish market has enjoyed meteoric growth, and now has some €153.96bn outstanding. This has been possible by pooling mortgages from a range of smaller savings banks into one arrangement, creating the euro market’s biggest player Ayt Cedulas at €14,300m. The highly seasonal residential mortgage market in Spain totals €385bn, lagging only the UK, Germany, France and the Netherlands.
In contrast with Spain, France and Luxembourg allow only mortgage and public sector lending specialists to issue Obligations foncières and Lettres de Gage. On the other hand, the geographical eligibility of the assets covering Obligations foncières is similar to Pfandbriefe, allowing EU and EEA countries, but without the 10 per cent cap per country other than Germany, France, Austria and Luxembourg. This is unlike Lettres de Gage, where assets may hail from any OECD member country.
While the currency of choice is usually the euro, issues in sterling, dollars, Swiss franc and Australian dollars are becoming more common.
In the UK and Netherlands, a contract-based system has developed. HBOS’s lead in the UK in replicating a covered bond using equitable assignment contract law has been followed by Abbey National, Bradford & Bingley, Northern Rock and Nationwide. These arrangements will be recognised by the Financial Services Authority from January 2007.
The FSA’s flexible approach to the scheme has been welcomed, particularly that there is to be no absolute cap on the level of issuance per originator, and no implications at all if covered bond issuance is less than 4 per cent of balance sheet. Where covered bond issuance is over 4 per cent but less than 20 per cent of balance sheet, a warning system comes into play and the authorities reserve the option to require revisions to capital ratio. Once covered bond issuance exceeds 20 per cent, adjustments to the capital ratio will invariably be triggered. The new regime will confer an incremental benefit in financial oversight, and is already broadening the product’s appeal to investors.
ABN Amro has calculated that the total volume of outstanding UK covered bonds would more than double, increasing by €29.5bn compared with the current volume of u25bn, should all the players issue covered bonds up to their 4 per cent threshold. Abbey (€9.1bn) and HBOS (€16.6bn) will be able to issue most before hitting the 4 per cent threshold, while to double the funding for Northern Rock and Bradford & Bingley would require adjustment to their capital ratios.
In Germany, another key change to the legislative landscape was the abolition last July of the state guarantees enjoyed by the nation’s Landesbanks, ending the uneven playing field within the German banking sector, and ushering in an era where Landesbanks will have to compete head-on with their private sector peers as the benefits from the grandfathering of guaranteed obligations progressively diminish. Public sector bond issues have consequently declined, while Pfandbrief issuers have increased their foreign business activities from around 30 per cent to 50 per cent.
“The overall volume of covered bond supply has increased markedly, met with an equally strong growth in demand, but arguably the number of public sector specialists has declined somewhat,” says Julia Hoggett, head of capital markets at Depfa Bank. “Public sector lending is a low risk, low margin wholesale business best suited to those institutions configured to specialise in it. As the Landesbank guarantees have fallen away, so the number of institutions appropriately configured to provide public sector covered bond supply appears to have declined as well.”
Small- to medium-sized covered bonds are usually between €50m-u500m but floating rate notes can be as much as €1bn-€1.5bn, while jumbo bonds are at least €750m at launch. Market-making occurs only in the jumbo market, with a minimum of three market makers, quoting two way prices with a fixed bid/offer spread of 1.5 basis points for lots up to €15m.
The diversification of the jumbo market will intensify, with up to 14 new issuers coming to the arena. ABN Amro predicts up to 71 different issuers, up from 57 at the end of 2005, from 14 different countries to issue up to 17 different products. The largest net supply will be delivered by Spanish Cédulas but much of the growth will also come from new markets. For instance, in Italy three banks are likely to launch inaugural euro jumbos in 2006. New issuers are expected to mainly target the medium part of the curve, but supply in ultra-long maturities will remain constrained because investors fear rising yields.
Genuinely global
In the US, issuers other than US agencies may also be looking to expand into other jurisdictions, which would transform the paradigm. “One question for the future is whether mortgage originators in the US might begin to utilise covered bond technology to refinance their portfolios,” adds Mr Hoggett. “While there are considerable technical constraints to this, if it were to happen, it would result in covered bonds becoming a genuinely global product.”
Another big issue is the Capital Requirements Directive in Europe, which offers a beneficial treatment if covered bonds meet specific standards. The various treatments in different jurisdictions should expand the range of possible risk weightings, while on balance the rules benefit highly rated banks and weaken the incentive to issue structured covered bonds with dynamic structural protections. In the event, issuer preferences will be driven by considerations such as the cost of arranging covered bonds versus AAA MBS, liquidity, and the desirability of maintaining different funding sources.
