Covered bonds are hot property across the world from Europe to Asia. But pending legislation and regulator concern mean demand is fast outstripping supply. Michael Marray reports.
Global demand for covered bonds continues to grow dramatically, as European accounts increase their allocation to the asset class, and new buyers such as central banks and private Asian and Middle Eastern investors show more appetite.
But supply is not keeping up with demand. Forecasts for 2005 suggest that overall issuance may be only 10%-20% higher than the €116bn for 2004. Such is the level of demand that order books on recent offerings have often been two or three times oversubscribed.
Bookrunners are hoping to see offerings from new countries in order to increase supply. But in Italy and Portugal progress has been slow on enacting the necessary legislation. The Cassa Depositi e Prestiti issue last month was a one-off, since it had its own statutes and did not rely on the long awaited Italian covered bond law. The deal had to be downsized and repriced but analysts attribute this to the bond’s 20%, rather than the usual 10%, risk weighting.
Slowdown in issuance
Meanwhile in the UK, a promising surge of initial issuance has been slowed down by Financial Services Authority (FSA) concerns about the amount of collateral being tied up in cover pools. And countries such as Sweden and Norway, which will have their debut offerings in 2005, are not big enough to make a serious impact on volume.
The result is a market where deals are hungrily bought up by the fast-growing investor base, and where spreads continue to tighten.
“Covered bonds have become a very popular product worldwide, particularly with central banks,” says Ted Lord, head of covered bond products at Barclays Capital in Frankfurt. “This is due in part to the euro’s strength against the dollar, and in part to the deteriorating fiscal situation in many G7 countries. With covered bonds, investors get top credit quality, a pickup in yield over sovereign bonds, and a diversified risk from the covered bond portfolio.”
Strong controls
“Investors also like the fact that covered bond issuers are on a very tight leash, and have strong controls on what they may and may not do. In contrast, governments may or may not live within their budget limits. The US has gone, within a few years, from having the largest budget surplus to the largest budget deficit in history. There are also serious budget deficit issues in Germany, France, Italy and Japan, to name a few,” says Mr Lord.
Achim Linsenmaier, vice-president, debt capital markets Frankfurt syndicate at Deutsche Bank, says: “The investor base is developing, especially among central banks, and that is partly because some central banks are moving away from holding big US dollar reserves, and covered bonds fit into their investment universe, as they want to place their currency reserves into liquid instruments which are offering an attractive yield.”
“Liquidity is very important, and in addition to offering a yield pickup, covered bonds have firm market making commitments from a number of banks, and are seen as the second most liquid instruments after government bonds,” he adds.
“Secondary market liquidity is a requirement for investors, since covered bonds are a substitute for government bonds, and investors need to be able to get in and out of positions quickly, at very tight bid offer spreads,” says Arturo Miranda, vice-president, responsible for securitisation in southern Europe at JPMorgan in London.
The biggest countries in terms of issuance are Germany, followed by Spain, though Germany is dominated by Pfandbriefe backed by public sector loans, while offerings of cedulas are mainly mortgage backed. Other countries have much smaller issuance volumes, and pricing is currently driven by scarcity value.
“French covered bonds are priced through the average German Pfandbriefe, and that is partly because the Obligations Foncieres law is regarded as one of the strongest, and also due to the scarcity of French issuers in the market, with only a handful of regular issuers,” says Mr Linsenmaier at Deutsche Bank. “Austrian covered bonds are also very well accepted by investors, and the tight spreads reflect the relative scarcity of issuance out of Austria.”
Recent deals out of both France and Austria have been enthusiastically received. In December, Credit Immobilier de France did a €1.25bn seven-year offering via its CIF Euromortgage issuing vehicle.
And in February, Kommunalkredit came to market with a 10-year E1bn offering, which priced at mid swaps plus five basis points (bps). The Kommunalkredit bonds were purchased by investors from across Europe and Asia, including France, Spain, the Benelux countries, Scandinavia, China and South Korea. Central banks, fund managers and insurance companies all came in on the deal, and such was the level of demand that the books were closed ahead of schedule.
Issuance out of Spain is much heavier, so pricing tends not to be affected because of scarcity value. Nonetheless deals in 2005 have had a very good reception from investors, priced at 10bps or 11bps over mid swaps even for comparatively long-dated 20-year paper. “There is currently a lot of demand, so spreads have narrowed, though this has been part of a general tightening across the credit markets, and not just in covered bonds,” says Mr Miranda at JPMorgan. “So far this year a number of Spanish issuers such as BBVA, Caja Madrid and La Caixa have taken advantage of currentmarket conditions with 20-year offerings.”
Shortage at short end
But the tightest pricing has been for those issuers at the short end of the maturity curve. One trend which had already started at the end of last year was that there was a lot of supply in 10-years-plus, not just covered bonds but also sovereign issues at the long end of the curve. This was driven by structural demand of pension funds looking for long-dated assets.
With a number of issuers going further and further out the curve and at higher volumes, there was something of a scarcity of shorter-dated paper, so early in 2005 a number of banks took advantage of this. A three-year €1bn offering for Hypo Essen deal was warmly welcomed by accounts looking for shorter dated assets, and was three times oversubscribed despite tight pricing of mid swaps minus 3bps. This deal was led by Barclays Capital, Deutsche Bank, Citigroup, and Commerzbank.
Heavy demand for covered bonds backed by mortgages is running parallel with strong appetite for residential mortgage backed securities (RMBS), though the two are seen as complementary.
“For issuers, covered bonds are more often attractive than RMBS, in terms of tighter pricing, lower-intensity documentation, and segregation of assets,” says Ron Thompson, head of ABS and structured credit research at Royal Bank of Scotland Financial Markets. “Covered bonds and RMBS are sold to different sets of investors, so using both sources of funding enables issuers to diversify their investor base.”
Meanwhile, the wait continues for the passage of covered bond laws in Portugal and Italy. The pending laws are partly a result of pressure from the domestic banking sector, which sees its European competitors with a very cheap source of funding which it does not enjoy. The Italian and Portuguese banks want the same as their counterparts elsewhere, and some have been impatient with the slow movement of covered bond legislation.
In Italy, the long awaited debut offering from Cassa Depositi e Prestiti will soon be launched, under what is planned as a €20bn programme of issuance. “Cassa Depositi e Prestiti is issuing under a special one-off law allowing it to segregate assets to satisfy the rights of covered bond holders, but other Italian issuers have to wait for parliament to enact the new covered bond law,” says Raimon Royo, director at Fitch Ratings’ European covered bond group in London.
Expected potential
“We expect this new law will be enacted this year,” Mr Royo says. “Once this law is in place there is huge potential for issuance of mortgage covered bonds. Italy is one of the largest economies in Europe, and the fourth largest in terms of RMBS issuance after the UK, the Netherlands, and Spain.”
Portugal recently saw a general election, and its new government will have other legislative priorities that may push back the passage of the new covered bond law.
The potential supply from Italy in particular should aid the development of the covered bond market, especially since the volume of bonds coming out of the UK has proved disappointing.
Investors readily accepted the structured covered bonds out of the UK, in the absence of any plans to pass a UK covered bond law. But after an initial rush of offerings, which began in 2003, volume has dropped off mainly because of an intervention by the FSA.
“The FSA in the UK is concerned that depositors are disadvantaged by the issuance of covered bonds, since if a large part of a building society’s balance sheet is used to back covered bond deals, then the depositors are effectively subordinated,” explains Bernd Volk, credit analyst for covered bonds at HVB in Munich. “The FSA has issued a guideline that no more than 4% of total assets should be used as collateral for structured covered bonds, and this is a particular disadvantage for building societies – for example, Northern Rock and Bradford & Bingley are already at this limit and at present cannot issue any more covered bonds,” he adds.
The FSA rules have led to falling volume in the UK market, though there are upcoming offerings from institutions such as HBOS and Abbey.
HBOS is the biggest issuer in the UK, and has done a series of deals, including public sector loans as well as mortgages. Last December, HBOS Treasury Services issued £500m worth of UK social housing covered bonds. These are backed by secured loans to UK housing associations, originated by bank of Scotland and Halifax plc. HBOS intends more offerings, having set up a £3bn UK social housing covered bond programme.
Issuance out of Ireland has been steadier than the UK, with the help of specific covered bond legislation. In 2004, total issuance was around E14bn, and there may be the same volume this year. Deals have included public sector bonds from Depfa Bank and the Dublin-based unit of WestLB. And last August, Bank of Ireland raised E2bn with the first offering backed by mortgages.
Hope for higher volume
With the help of the Cassa Depositi offering, and debuts anticipated in 2005 from both Sweden and Norway, total volume should rise in 2005, though not be enough to satisfy the huge appetite on the demand side.
Analysts note that so far in 2005, the amount of cash looking for a home is overwhelming, and the level of deal oversubscription is at high levels. As a result, the marketing period has contracted for many offerings. Investors need to find something do with their cash, and one analyst has characterised the market for asset-backed securities and structured bonds as having a “buy now, analyse later” atmosphere.
But underwriters’ caution against complacency, and they stress that building relationships with the investor base remains important, rather than taking a short-term view over the immediate offering.
Most covered bond deals continue to be launched with extensive roadshows, as issuers make efforts to expand the investor base, and to get to know investors for the more difficult market conditions that may lie ahead in the future.
