The fortunes of the covered bond market varied wildly from country to country during the subprime crisis, leaving investors facing tougher choices on where to put their money, says Michael Marray.

The current crisis on global capital markets has spared no single asset class, but covered bonds have performed better than most, even if they have failed to live up to the hype of 2006 and early 2007.

At that time, covered bonds were widely marketed as a rates product rather than a credit product, with excellent liquidity and spread stability. But since last July, covered bond investors have endured spread widening of 40 basis points (bp) to 50bp on many issues and there has been a short temporary suspension of interbank market making, and a tripling of bid-offer spreads that remains in place today.

Success stories

However, in spite of these negative headlines, it is notable that the primary market has remained open for top-class issues from countries such as Germany, France and Norway, and that a number of Canadian banks have pressed ahead with their debut offerings in the fourth quarter of 2007 and the first quarter of 2008.

The situation is more difficult for issuers from the UK and Spain, and during January and February this year there were no deals from those two jurisdictions. The market has moved from one with very little tiering, to one where investors are being very conservative about whose issues they want to buy.

Quality focus

“Investors are very credit focused and in the current environment, issuers need to market their covered bonds in much the same way as a senior secured transaction,” says Armin Peter, head of covered bond syndicate at UBS in London. “As well as looking at the underlying mortgage pool and the outlook for the property market, investors are looking very closely at the credit quality of the underlying institution, and want to hear about its business model, cost-to-income ratios, current liquidity position and other balance sheet data.

“For issuers out of Germany, France and Scandinavia the number of accounts interested in buying has fallen only marginally, but for countries with more headline risk, such as the UK, Ireland and Spain, the number of interested accounts has dropped severely, making it difficult to find agreement on pricing levels acceptable for the issuer.”

Ted Lord, managing director and head of covered bonds at Barclays Capital in Frankfurt, says: “With several negative surprises over the past couple of months in the financial markets, the senior management of many investors have become very cautious.

“Investors are now more interested in meeting with the senior management of covered bond issuers. They want to get a sense of the direction of the firm going forward and who is steering the process. So for many covered bond issuers, the task in 2008 is not to solely convince the portfolio managers, but their senior management as well.”

Derry Hubbard, head of covered bond marketing and execution at BNP Paribas in London, says: “Investors are being more cautious, and they want to tick all the boxes in terms of the underlying credit and issuer story, and the outlook for the underlying mortgage or public sector lending market where the collateral is being originated.”

He adds that there are significant redemptions during 2008 in the German jumbo pfandbrief market, where the total volume of covered bonds outstanding will shrink again this year. This means that non-German public sector issuers such as Dexia Municipal Agency (Dexma) and Depfa ACS, as well as public sector pfandbrief issuers, should continue to enjoy a differentiated bid, especially from central banks.

Robust offerings

German issuers of mortgage-backed covered bonds are also seeing strong appetite from investors, and in January, Deutsche Postbank came to market with its inaugural mortgage pfandbrief offering, lead managed by BNP Paribas, Citigroup and Deutsche Bank. The five-year, €1.5bn deal generated €6bn worth of orders from 100 different accounts, and priced at mid-swaps plus 2bp.

“The most robust names and stable jurisdictions are still getting very broad investor penetration and the Postbank transaction was 37% sold into Germany, together with good international distribution, and a total of 100 individual accounts buying the bonds,” says Mr Hubbard.

Another well received deal in the first quarter was for SEB, which came with a €1.5bn, three-year offering lead managed by UBS, Goldman Sachs, UniCredit and SEB. Initial guidance was at mid-swaps plus 4bp, but the deal printed at 3bp-plus, with orders totalling €4.6bn.

Big deals

BNP Paribas was in the market in the third week of January with a €2bn, three-year structured covered bond which printed at mid-swaps plus 13bp. And soon after, from Norway, DnB NOR came with a €2bn, five-year offering at an 11bp spread. On the public sector side, Dexma and Depfa Deutche Pfandbrief have also done deals.

“The big advantage for German pfandbrief issuers is that they have a tremendously large domestic investor base,” says Florian Hillenbrand, covered bond analyst at HVB in Munich.

“One year ago, perhaps 50% of all covered bonds were placed in Germany, but these investors are now concentrating on the product that they know best, which is the pfandbrief,” he adds. “France also has a very solid domestic investor base, but other jurisdictions such as the UK are now facing the consequences of not having made enough effort to develop their own domestic investor base.”

Ralf Welge, head of public sector and covered bond origination at Commerzbank Corporates & Markets in Frankfurt, says: “The cost of senior unsecured funding has increased dramatically for banks, which makes covered bonds a very attractive funding source and more than justifies the costs associated with setting up and running a programme.”

Changing environment

Early in 2007, new issuers such as Canadian banks were looking at setting up covered bond programmes as a way to diversify their funding sources and investor base, rather than being driven by lower cost of funding; but the environment has now changed.

“There has been some volatility in covered bond spreads, but as a rule of thumb you can currently issue new bonds at a 6bp premium over secondary market levels, which is influenced by the wider bid offer spreads,” says Mr Welge. “In contrast, it is very hard to predict what spreads might be for a senor unsecured offering, which is causing great uncertainty for bank issuers.

Niko Giesbert, managing director and co-head of debt capital markets financial institutions Europe at Morgan Stanley, says: “There is good investor appetite for deals from highly regarded names from countries such as Germany and Norway, and we have seen strong demand for public pfandbrief offerings, as well as private placement tickets in euros and dollars. So far in 2008 we have seen three- or five-year transactions, and some issuers are now looking at seven years, although the 10-year part of the curve is still rather costly.”

Landesbank Baden Wuerttemberg recently came to market with a five-year offering at mid swaps minus 1bp, led by Morgan Stanley and Natixis. The €1.5bn deal attracted €5bn worth of orders.

Quality focus

“There was a strong book that included insurance companies and central banks, with a lot of international demand as well as German investors, and no orders were pulled when pricing was tightened from initial guidance,” says Mr Giesbert. “The new issue premium is gradually coming down, and a steady new issuance platform is coming back for top names. Transparency is the key word, and investors putting their money to work are looking much deeper at aspects such as the mechanism of the pool, the quality of assets in the pool, and also the situation at the bank behind the deal.”

Waiting game

For many issuers, the spreads currently demanded by the market, and the risk to their reputation of having a failed deal, means that they are playing a waiting game, and hoping that by the second half of 2008 the market will once again be able to absorb a significant amount of primary mortgage-backed issuance.

Several Spanish banks have been either holding roadshows or undertaking some quiet pre-marketing over the past six months, but have been forced to put deals on hold.

But some big-name Spanish banks are expected to tap into the market during the first half of the year. More problematic are multi-cédulas, which are packages of covered bonds pooled by regional banks. These are harder to analyse from the point of view of looking at the underlying institution and small savings banks often have weaker credit quality, less diverse earnings and would be more exposed to a major property crash.

At time of going to press, multi-cédulas issuer AyT Cedulas Cajas was undertaking a non-deal-specific roadshow across Europe with the aim of sounding out investors and hearing their views on the market.

“Market conditions are extremely difficult, with investors shying away from Spanish covered bonds, and at current spreads it is unlikely that we shall see many Spanish issuers attempting to tap into the market,” says Arturo Miranda, executive director at JPMorgan in London. But he notes that most Spanish banks are well placed to wait for conditions in the covered bond market to improve.

“In 2006 and 2007, Spanish banks were very actively funding themselves, and Spain was one of the jurisdictions better known for accessing the longer end of the curve with a large number of 10-year offerings, so they have long dated maturities in existing cédulas,” says Mr Miranda. “Spanish banks are also experiencing slowing growth in their assets, and there has been a massive inflow of retail deposits, including money that has been switched out of mutual funds.”

Liquidity levels

Interestingly, during the fourth quarter of 2007 and the first quarter of 2008 there was a widespread perception that Spanish banks were some of the heaviest users of European Central Bank liquidity lines because of the credit crunch. This was unfounded, with their borrowings dwarfed, for example, by those from German banks. Yet Spanish banks have been very busy structuring asset-backed securities transactions and retaining AAA tranches. Having already done all the time-consuming structuring work, they have tens of billions of euros-worth of ready-made European Central Bank AAA rated collateral at hand in case added liquidity is needed.

Against this background, it is clear that most Spanish banks will be able to avoid being pressured to issue cédulas at wide spreads. Similarly, UK issuers are waiting for conditions to improve, although it is likely that a top name such as HBOS might re-open the market in the coming months, at the short end of the curve where spreads are tighter.

Glimmer of hope

“The market is very difficult for Spanish and UK issuers, partly because German investors are currently buying fewer foreign assets than in the past few years,” says Bernd Volk, director at Deutsche Bank in Frankfurt. “Yet the market is not completely shut for Spanish and UK issuers, and we have seen a few successful private placements,” he adds. “Short-term Spanish and UK public offerings with a decent spread might work even in the current environment, yet, the market is particularly challenging for Spanish multi-cédulas.”

SOME EXPECTED DEBUT ISSUERS DURING 2008

  • Banco Popular
  • Bankinter
  • Danske Bank
  • Nykredit
  • Crédit Agricole
  • SNS Bank
  • ING Bank (completed)
  • Barclays Bank
  • Abbey National Services

Various sources

NEW ISSUERS AND COVERED BOND LAWSIn the current environment, investors want the simplest and best-known covered bond products, and primary issuance is made up mostly of top quality German, French and Scandinavian names, plus some new entrants from Canada.But the underlying trend in global covered bonds is one of growing diversity, and as the market hopefully stabilises in the third or fourth quarter of 2008, investors will have more products to choose from and more analysis to do. Both contractual covered bonds and those based on legislation are on offer. In well-established markets such as France and Germany, contractual covered bonds have appeared alongside the obligations foncières and pfandbrief, with contractual deals from BNP Paribas and Landesbank Berlin.Canada passed covered bond legislation in 2007 and Canadian banks are finding favour with international investors in spite of the difficult market environment. The first deal came from Royal Bank of Canada last November, and this was followed up by a transaction from Bank of Montreal.US issuers did their first deals in late 2006 and early 2007 but the development of the US market has been severely disrupted by the global credit crisis and an issuer such as Bank of America will have to wait for conditions to settle down before it can do a deal.Italian legislation is now in place and the first deals are expected this year. The Netherlands has no covered bond law, but there are contractual covered bonds, and ING Bank is the latest institution to set up a programme.UK legislationMeanwhile, in the UK the establishment of a covered bond market has followed an unusual path, with a thriving contractual covered bond market being developed in recent years, ahead of legislation which was passed in March.During the first half of 2007, the spread pick-up versus the long established pfandbrief and UK contractual covered bonds had narrowed to a few basis points. That proved to be short lived, as secondary market spreads on UK issuers have ballooned outwards by between 30bp and 40bp.A well-regarded UK issuer such as HBOS would find it hard to justify issuance at current spreads, but UK banks may well re-open the market at the short end of the curve as spreads settle down again.One thing in favour of the UK issuers is that the new covered bond law will, for the first time, make their bonds compliant with an EU directive on undertakings for collective investment in transferable securities (UCITS), making them eligible for a 10% risk weighting for investors, compared to 20% at present.Quality benchmark“Everyone wanted the UK regulated covered bonds regulations to be seen as a quality benchmark, and accordingly, while there is a broad definition of eligible property in the relevant EU directive, in some ways the UK legislation tightens that,” says Angela Clist, partner at Allen & Overy. “UK law requires that if residential mortgage-backed securities or commercial mortgage-backed securities tranches are to be included in the asset pool, the underlying loans must have been originated or acquired by the issuer or a connected entity situated in the UK, and those residential mortgage-backed securities and commercial mortgage-backed securities must have an AAA rating.”Law queries“A question arose at the drafting and consultation stage as to whether to allow UK branches of foreign banks to issue regulated covered bonds, as long as they used the UK structured approach whereby the assets were held in a separate vehicle with its registered office in the UK, and would be subject to UK insolvency proceedings,” adds Ms Clist. “But it was eventually decided not to include such issuers within the new law.”  UK programmes were due to be registered with the Financial Services Authority in late March, and it will keep a register of issuers. The first UCITS-compliant UK deals could be done by the end of the first half of this year, market conditions permitting.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter