Covered bonds continue to gain acceptance, with new issuers increasingly attracting the traditional pfandbriefe investor. Should they wait for covered bond legislation or go the structured route? Michael Marray finds out that there is a big market for both.

The volume of European covered bond issuance is on course to set a new record for 2004 and bankers believe this growth trend will continue next year, augmented by first-time issuers from countries with new covered-bond legislation.

Both Sweden and Norway have recently established covered-bond laws and the first deals are expected early next year.

Portugal and Italy are also likely to pass covered-bond laws and get their first deals done some time in 2005.

But it is not only countries with specific covered-bond legislation that are seeing a boom in issuance. During 2004, the main focus on new issuers has once again involved UK structured bonds, which are not backed by any covered bond law. Since HBOS launched the groundbreaking first deal in summer 2003, it has been back with four subsequent offerings, and there have also been deals from Northern Rock and Bradford & Bingley.

Gaining acceptance

These structured deals still trade at a pickup of a few basis points compared to traditional pfandbriefe, but the process of gaining investor acceptance has been very rapid.

“Many investors feel as comfortable with UK structured bonds as they do with bonds from European jurisdictions where there is a covered bond law, though, as a result of the 20% risk weighting, you need to put perhaps an extra basis point on the table,” says Marcus Guddat, director in fixed income syndicate at Citigroup in Frankfurt

That pricing constraint aside, Mr Guddat stresses that because most of the investors are not banks, they are often relatively comfortable with the higher risk weighting. “Insurance companies, central banks and asset managers are not affected by the 20% risk weighting and, in Germany, many smaller savings and co-operative banks do not have a problem with a 20% risk weighting, because they are very well capitalised.”

In terms of league table status and customer flows, as well as in secondary market trading, the covered-bond market is becoming increasingly important. “This is benefiting investors, who want to see a well organised market with large, highly liquid offerings, and standard market making agreements,” adds Mr Guddat.

Trading volume

Over the past few years, great progress has been made in ensuring a highly liquid secondary market with low bid/ask spreads, and bankers say that trading volume and the number of covered bond market makers has grown rapidly.

Trading systems such as EuroCreditMTS have been experiencing strong growth in trading volume. Initial rules set out in 2000 stipulated a €3bn minimum deal size, but in practice, this is quite large for covered bond offerings, so this year, EuroCreditMTS reduced this to €2bn.

“In addition to having at least one triple A-rating and a minimum deal size of €2bn, there must be at least seven banks quoting an issue to ensure sufficient liquidity in the secondary market,” explains Laurent Viteau, head of covered bonds at EuroCreditMTS in London. He adds that, in practice, there are usually anywhere between 10 and 15 market makers quoting prices.

And the number of dealers looks set to continue growing. “Additional countries are moving to introduce covered bond legislation and, in countries where no legislation is envisaged, individual issuers are looking to do structured deals, so primary issuance is growing fast and over the last six to 12 months, more and more dealers have entered the market,” says Mr Viteau.

Investor base

The breadth of the investor base is a notable feature of the market; there are buyers in traditional western European financial centres, but also heavy buying across eastern Europe and in Asia. It is a sign of the way the market is developing that the UK structured product has also proved to be highly popular with German investors, who are the conventional buyers of pfandbriefe.

“The first HBOS deal had some overlap with existing HBOS investors and roughly the same quantity of bonds were bought by UK investors as by German investors; but on subsequent structured covered bond offerings out of the UK, there has been a trend towards traditional investors buying into deals, with the single biggest group of buyers coming from Germany,” says Richard Kemmish, director, capital markets at Dresdner Kleinwort Wasserstein in London.

Mr Kemmish notes that the first HBOS roadshow included traditional fund manager destinations such as Edinburgh, Madrid and Milan, while more recent roadshows for UK covered bond deals have included stops in cities such as Budapest, Wiesbaden, and Nuremberg.

“Central banks are coming more into structured covered bonds and as investors such as UK hedge funds have declined in relative importance, small ticket German investors have increased in importance,” he says. “When you sell to the Landesbanken, the ultimate buyer via their regional distribution networks may often be small ticket retail investors.”

Hybrid deals

With regard to the distinction between structured bonds, and those based on legislation, bankers point out that there are also hybrids in the market. For example, in Spain, smaller banks group together to reach a critical deal size and put some added credit enhancement in place to issue what are known as structured cedulas.

Cedulas are a highly international product and investors buying the structured variety have shown themselves to be comfortable doing the extra analysis required because of the structuring.

“Most cedulas are sold to non-Spanish, European investors and we are seeing more interest from the new EU member countries, but Spanish investors are now also buying more cedulas,” says Avelino Abellas, head of origination for Spanish banks at Credit Agricole Indosuez in Madrid.

And in Ireland, a recent deal from the Bank of Ireland also featured some additional structural enhancements, even though it was based on legislation. As one banker comments: “It is hard to say where structured ends and plain vanilla begins.”

The e2bn Bank of Ireland offering of five-year bonds illustrates the high level of investor demand that has characterised the market this year. It was the first Irish mortgage covered securities (MCS) deal, since previous Irish transactions under the 2001 Asset Covered Securities Act were backed by public sector loans rather than mortgages.

The deal was launched on September 13, led by Barclays Capital, Deutsche Bank and Citigroup, and within a few hours orders had piled in from all over the world to a total of more than e7bn. Bank of Ireland was thus able to price the bonds at mid-swaps plus 3bps. As a comparison with the market early in 2004, in February. HBOS launched five-year covered bonds at mid swaps plus 9bps, which tightened in to 4bps by October.

“The Bank of Ireland issue was able to be priced much tighter than they had initially anticipated, because of the overwhelming demand, which included many first-time buyers of Bank of Ireland risk,” says Ted Lord, head of covered bond products at Barclays Capital in Frankfurt.

Beyond Europe

“Investors feel very comfortable with covered bond instruments, and there is a general move from government bonds into covered bonds,” says Mr Lord. “We are seeing strong demand from the Middle East and Asia, as well as from European investors. So many countries have passed legislation, or are working on new laws, that investors are increasingly able to mirror government bond portfolios from all these different countries – and get a higher spread.”

Of course, spreads have tightened in during 2004 across the fixed income universe, including asset-backed securities (ABS), but bankers believe that covered bonds are establishing themselves as a favoured asset class that will be less likely to widen out in the event of a general credit widening.

Structured issuers out of the UK are currently pressing the Financial Services Authority (FSA) to rule that the UK structured bonds qualify as covered bonds under Article 22.4 of the EU directive governing Undertakings for Collective Investment in Transferable Securities (UCITS).

If the FSA does that in co-operation with the European Commission, then bonds such as those from HBOS will also benefit from a 10% risk weighting. Issuers are also keeping an eye on how the Basel II capital adequacy rules will affect issues. Basel II does not directly address the covered bond sector, but if the risk weighting remains at 10% then the risk weightings given to ABS could impact the market in terms of the relative attractiveness of covered bonds versus ABS.

Collateral concerns

There is one cloud on the horizon in the UK: the FSA has recently raised concerns about the amount of collateral being set aside to cover pools for covered bonds, because of concerns about depositors being subordinated to covered bond investors.

This has led to some erroneous market reports that there may be a 4% balance sheet limit, when in fact bankers say that the FSA has simply noted that 4% of some issuers’ balance sheets have now been put into cover pools. The FSA has simply signalled to the market that it is keeping an eye on the volume of covered bond issuance.

The launch of the HBOS deal, and the ready acceptance of the structured covered bond product by investors, was a big event for the European market, because it showed that the structured route was just as acceptable to investors as the traditional legislative framework.

This has made jurisdictions such as Italy and Portugal speed up work on new laws, realising that banks might simply press ahead with structured deals. Investment bankers suggest that Italian commercial banks would have done their own structured deals by now if the government had not said that it is giving covered bond legislation priority status.

In fact, Italy’s state-owned Cassa di Depositi e Prestini has already had its statutes amended to issue covered bonds, and should launch its first deal late this year or early next. But Cassa di Depositi e Prestini is governed by its own laws, and the commercial banks are still waiting for a covered bond law applicable to them.

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