Though Germany and Spain remain the main issuers of covered bonds, this product is now receiving attention from investors across Europe. Michael Marray finds out why.
A growing number of issuers have been taking advantage of tight spreads in the European covered bond market, and there were E16bn worth of deals in the pipeline for September and October, with issuers from countries such as Germany, Austria, Spain and Ireland.
The covered bond product has enjoyed growing investor acceptance during 2003, proving to be attractive to conservative investors, many of whom are diversifying their government bond portfolios at a time when countries such as Germany and France are worrying the markets by breaking Maastricht limits on budget deficits.
This has encouraged arrangers to make a major marketing effort, bringing in first-time buyers on deals by familiarising them with the mortgages or loans to public sector entities, such as municipalities that provide the underlying collateral.
However, with so many issuers coming to market, some deals being sold in mid-September were encountering resistance from investors who feel that pricing has become too tight. High liquidity across the bond markets during the course of the year has encouraged underwriters to pitch highly aggressive target funding spreads to issuers in order to win mandates.
According to analysts, some offerings may be postponed if the arrangers are unable to deliver. Nonetheless, even if some covered bond deals are held back for a few weeks, bankers believe that most issuers will continue to find the product attractive as an alternative to either unsecured offerings or securitisations.
Iain Barbour: “The HBOS covered bond creates a sustainable triple-A rating”
Ted Lord: Covered bonds “offer a good spread over European government bonds”
Issuance leaders
The biggest country of issuance remains Germany, with its public sector and mortgage Pfandbriefe product, and there is also heavy issuance out of Spain, via Cedulas Hipotecarias (backed by mortgages) and Cedulas Territoriales (backed by public sector loans). And in countries where no specific covered bond legislation exists, deals are being structured with the help of securitisation techniques.
The newest entrant to the market is the UK, where in July of this year HBOS launched a E3bn deal, effectively de-linked from the issuer’s senior unsecured rating with the help of structures more often seen in the securitisation market. The seven-year offering was priced at 10bp over mid-swaps, and was led by Citigroup, Dresdner Kleinwort Wasserstein (DrKW), and Goldman Sachs.
“We have a large appetite for funding, and since the covered bond market was one that we had never been in before, offering us investor diversification, we saw the deal as something that would benefit us in the long run,” says David Balai, head of capital markets and securitisation at HBOS Treasury Services in London.
“There was a good price differential versus our unsecured senior debt, but we were also looking to extend our liability profile, since our MTN [medium-term note] offerings generally go out as far as five years,” he adds. With covered bonds, HBOS will have the ability to issue with maturities of 10 years or even longer, though in the case of the debut offering, market conditions led to a decision to issue seven year bonds.
“We view the covered bond market as an important element of our wholesale funding, and the intention is to use this market on a regular basis, issuing in size, to generate liquidity and investor interest,” Mr Balai says, adding that this will be done alongside HBOS’s programme of residential mortgage backed securities (RMBS) offerings via Permanent and Mound Financing – the two existing securitisation programmes used by HBOS. “We need both markets, so they are complementary,” he says.
German investment
For issuers outside of Germany, the German investor base is very important, not only because of its size, but because they are already familiar with covered bonds as heavy buyers of Pfandbriefe. For this reason German underwriters tend to be heavily featured on covered bond syndicates, and the HBOS deal featured not only DrKW as one of the leads, but also DZ Bank, WestLB and LB Baden Wuerttemberg as co-leads.
Around one-third of the HBOS issue was placed in Germany, with the UK and Ireland accounting for another quarter. As is usually the case with covered bond placement, pension funds and other asset managers were the heaviest buyers of the paper, followed by insurance companies and banks. Some was also placed with central banks.
“Investors have been shifting out of assets such as bunds and OATs because of the deficit problems in Germany and France. In addition, the accounting issues surrounding Freddie Mac (in which the US government-backed organisation understated earnings to meet bankers’ expectations) have encouraged more investors to diversify their portfolios into covered bonds as they are seen as an attractive alternative,” says Ted Lord, director and head of covered bond products at Barclays Capital in Frankfurt.
“We are selling a lot of covered bonds to central banks who are investing their reserves, because they are highly rated instruments with a liquidity agreement among the syndicate members, and they offer a good spread over European government bonds,” Mr Lord explains. “Insurance companies are looking for guaranteed income over a period of time, and liquidity is also very important to them. Pension funds and large asset managers are also buying these instruments, as are private individuals around the world.”
Arrangers are also increasingly marketing covered bonds in central and eastern Europe, and earlier this year Barclays roadshowed the issues for CIF Euromortgage, La Caixa, Hypothekenbank in Essen, and DG Hypothekenbank, in eastern European cities including Zagreb. “Eastern European investors have bought a lot of bunds in the past, but want to diversify, especially since the German government is having budget problems,” says Mr Lord. “These eastern European investors are interested in the significant per annum yield pickup that they can get in covered bonds without sacrificing on credit quality.”
Long-term goals
The type of investor who buys covered bonds typically wants a long-term bullet (single principal repayment when the bonds mature) structure and does not wish to deal with quarterly repayments associated with mortgage pass-through bonds. Thus, for covered bonds backed by pools of mortgages, the issuer can sell covered bonds without negatively impacting demand for their securitisation offerings.
“Interest rates are low at the moment, and issuers are looking for fixed rate funding,” says Alexander Batchvarov, head of international structured credit research at Merrill Lynch in London. “The more traditional ABS investor is buying a pass-through floater, whereas covered bonds are fixed bullets and longer maturities than the floater. Buyers of covered bonds would typically also be buying government and quasi-government bonds, so they are used to buying longer maturity bullets.”
Future entrants
More UK deals are expected, with mortgage lenders such as Bradford & Bingley expected to enter the market. And earlier this year the Irish Stock Exchange launched its new rulebook for covered bonds, prior to the launch of the first covered bond under Irish law for Depfa Bank.
“The HBOS covered bond creates a sustainable triple-A rating through robust and dynamic structural features, rather than a legislative framework as is the case in other European jurisdictions,” says Iain Barbour, head of asset backed securities at Commerzbank Securities in London.
“The structure is also expected to be of interest to other UK issuers as a complement to existing senior unsecured, securitisation and retail deposit sources of liquidity, and should appeal directly to those with senior unsecured funding costs in double digits, as well as those seeking to extend their liability maturity profile,” says Mr Barbour.
Spanish offerings
Elsewhere in Europe one of the busiest markets is Spain, where there are regular offerings of bonds backed by both mortgages and public sector loans. Earlier this year Banco Santander Central Hispano (BSCH) sold its debut E2bn Cedulas Territoriales public sector loan deal, in a transaction that attracted some criticism for what was seen as over-aggressive pricing. Another offering involved a group of smaller mortgage banks pooling their loans to launch the E1.75bn TDA Cedulas transaction (TDA stands for Titulizacion de Activos and is a securitisation structure established under a Spanish law passed in 1998).
In mid-September, BSCH was preparing another deal, this time a E2bn Cedulas Hipotecarias offering led by Citigroup, Credit Agricole Indosuez, Goldman Sachs, HSBC and BSCH. It was launched quite aggressively at Euribor plus 9bps, but was nonetheless well received by investors, say the bookrunners.
Santiago Ruiz Morales, executive director at Credit Agricole Indosuez in Madrid, anticipates that Spanish covered bond issuance will grow alongside the securitisation market. “They go to completely different investors, so they are complementary instruments, and there are a number of issuers who issue simultaneously,” he says. For example, Alicante-based Caja de Ahorros del Mediterraneo put E350m of collateral into the TDA Cedulas pooled offering, while around the same time it was launching its own E1bn RMBS deal under the name TDA CAM.
“Cedulas are quick to issue, and cheap, while RMBS save on capital requirements, though are more expensive to arrange,” says Mr Ruiz Morales. “Most banks that issue Cedulas in Spain are highly capitalised anyway, and some are issuing Cedulas instead of euro medium-term notes, so they are replacing more expensive unsecured debt.”
Most Spanish covered bonds are sold outside of Spain, notably in Germany and France. Spanish issuers are expected to be busy in the remaining months of 2003, including a deal from Caja Madrid. And in spite of the growing volume of issuance coming to market from Spain and other countries, arrangers expect the investor base will be able to absorb the paper without too much difficulty.
