As more jurisdictions join the covered bond market, investors are taking the opportunity to diversify their portfolios. Michael Marray looks at which countries are making waves.

New jurisdictions are continually being added to the covered bond universe as governments pass laws to help their financial institutions gain access to a cheap and stable source of funding. Last year, the first deals took place under new laws from Portugal and Sweden. Already this year, Turkey has passed a covered bond law, and legislation is on the way in Italy and Norway.

Issuers from new jurisdictions generally get a good reception, because covered bond investors are seeking diversity in their portfolios. This was the case with the first deal out of Portugal last November, a €2bn 10-year offering from Caixa Geral de Depositos.

“Whenever a new borrower comes to the market or a new jurisdiction joins the covered bond world, one of the big drivers on the first few issues is a diversification bid,” says Armin Peter, head of covered bond syndicate at UBS. “The investor base for covered bonds is broadening, and these investors want to grow their portfolios and diversify their covered bond holdings at the same time.”

Arturo Miranda, executive director at JPMorgan in London, says: “At the end of last year, we saw the first ever covered bond out of Portugal, and other Portuguese banks are likely to access the market this year. We may see three or four benchmark deals, all €1bn or larger, during 2007.”

The Caixa Geral bonds were able to achieve an AAA rating, which may not be the case for some other major Portuguese banks with lower senior unsecured ratings, even though some have recently been upgraded after the global review of bank ratings conducted by Moody’s.

“It may depend on the quality of the collateral and, given the relatively low LTVs [loan-to-value] that are common in Portuguese portfolios, I would expect that the banks that are planning offerings will be able to get to AAA, though some deals may have a single AAA rating,” says Mr Miranda. “In any case, the difference in spreads between AAA rated and AA rated covered bonds has narrowed in recent years, so the AA market may still be attractive to some issuers.”

The benefits of diversification

It is not just bonds from new jurisidictions that benefit from the diversification, but also new issuers coming out of long-established markets.

“New names such as HSH Nordbank, with its inaugural public pfandbriefe at the beginning of 2007, as well as new jurisdictions such as Sweden and Portugal, which already entered the covered bond market in 2006, have been well received because they allow investors to diversify their portfolios,” says Bernd Volk, director at Deutsche Bank in Frankfurt.

“The debut offerings expected during 2007 from new issuers in Sweden, Portugal, the US and maybe Italy and Denmark are also likely to get a good reception from investors looking for diversification,” says Mr Volk.

“In Italy, given the size of mortgage portfolios, and taking into account planned issuance limits by the Bank of Italy, there is an issuance potential of up to €170bn from Italian banks, once the pending secondary legislation is passed by the Bank of Italy.”

Analysts are divided over whether the Italian law will be passed in time for the first deals to close before year end, with some suggesting that the long-awaited arrival of Italian issuers will not happen until 2008.

Turkey moves onto the stage

The delays have allowed another newcomer to the covered bond world, Turkey, to move ahead of Italy. The Turkish government recently passed its law, opening the way for issuance during 2007.

According to Claudia Sigl, covered bond analyst at BayernLB in Munich, the laws governing Irish asset-covered securities (ACS), Spanish cédulas and, in particular, German pfandbriefe are the godfathers of the new Turkish law. “Elements of the German law appear relatively frequently, since the Turkish legal system in many areas is very similar to the German system,” she says. “Nonetheless, there are still many differences from the German law, such as the LTV limit of 75%.”

The Turkish covered bond law basically provides for two types of issues. Mortgage-covered bonds (MCB) will be backed by home mortgages, while asset-covered bonds (ACB) can contain every kind of securitised asset permitted by the securitisation law. Within MCBs, commercial real estate mortgages are limited to a 15% ceiling. If commercial real estate loans account for more than 15% of the security, then the deal must take the form of an ACB. The cover pool for these can include up to 100% commercial real estate mortgages or can include other types of receivables, such as credit card receivables and mortgages from the public sector.

Market complexity increases

The growing variety of product presents its own challenge to investors wanting to do some relative value analysis on each deal that they buy, and the market is undoubtedly becoming more complex as new structures and jurisdictions appear. “Investors need to be aware of the structural differences between covered bonds from different jurisdictions, as well as the differences between the various contractual covered bonds from issuers in the US and UK,” says Helene Heberlein, head of covered bonds at Fitch Ratings.

“In some countries, you will see offerings of both contractual covered bonds and bonds issued under the covered bond law. That is now the case in France, where BNP Paribas recently decided to go outside the framework of the covered bond law to issue a contractual covered bond,” she says.

In spite of the wide variety of laws and structures that have to be analysed, most investors welcome the broadening of the issuer base because it allows them to grow their portfolios without increasing concentration risk. They already have very large holdings of German pfandbriefe, with jumbo issues out of Germany making up about €50bn of the €180bn of new jumbo issuance in 2006.

Spanish big on jumbos

German public sector pfandbriefe used to dominate the covered bond world but, as public sector issuance has dropped off and MCBs have made up most issuance, Spain has emerged as the largest issuer of jumbos.

In Spain, growth in residential mortgage lending is moderating, although it is still running in the mid-teens, so Spanish banks’ funding needs will continue to be sizeable during 2007 for both RMBS and covered bonds. The country will again be in either first or second place for jumbo covered bond issuance.

Because of this very heavy supply, spreads on Spanish cédulas tend to be wider than those from jurisdictions such as Germany or the UK. In March, the AyT Cédulas Series XII deal, which raises funding for a group of Spanish savings banks, was in the market with a €2bn 10-year offering, which priced at mid-swaps plus 7.5 basis points.

Spanish issuers may want to tap into the new domestic US market to broaden and deepen their investor base, and ensure that demand keeps up with their heavy supply.

Underwriters generally expect investors all over the world to have a strong appetite for new product this year. Covered bonds are appearing in more bond indices that investors track and there is still ample liquidity in the markets. In addition, there has been some reassessment of risk in the first quarter of this year, and more investors are attracted to the high credit quality that covered bonds offer and their impeccable payment record.

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