ABN AMRO’s Christoph Anhamm explores the reasons behind the growth of covered bonds and considers future market drivers.

The covered bond market is attracting serious attention from many banks looking to expand their future funding choices. This interest is due to several factors: regulatory changes (IAS 39 and Basel II) which increasingly affect the banking industry; funding advantages; and the excellent track record the product offers. Covered bonds will help banks obtain easier access to international capital market, lower funding costs, access to a wider investor base and an increased scope of balance sheet management flexibility.

Over the past decade, the product has received a positive reception in an increasing number of European countries and, at ABN AMRO, we expect it soon to be adopted by the banking industries in other continents.

Fundamental characteristics

Covered bonds offer banks the opportunity for a quasi on-balance sheet securitisation of assets. The respective assets are registered as collateral for the outstanding covered bonds and remain on the balance sheet of the institution originating these assets and bonds respectively. Typically, this does not mean that a specific number of earmarked assets are collateralising any individual bond. Instead, the entire portfolio of registered assets collateralises all of the outstanding covered bonds issued. In the event of bankruptcy by the issuer, covered bondholders have a preferential claim on the cash flows generated by the registered assets.

To date, only mortgages and public debt which meet specific quality standards, have been used as collateral. The low risk nature of these assets has added security and confidence to the product, resulting in a notably higher credit rating compared to the unsecured debt of the issuing bank.

Framework

Aside from this core element of ring fencing the covered bonds, several other components are added to increase investor protection and thus the rating and the acceptance of covered bonds by the international investor base.

Most European countries have implemented strictly supervised legal frameworks regulating the structure of their national covered bond system. In countries that lack a defined covered bond system, banks have started replicating this legal framework via contractual agreements that are based on the respective civil or common law. The aim should be to ensure all covered bonds issued out of one country achieve a relatively high degree of homogeneity and standardisation. This keeps ‘structuring costs’ low as well as notably easing the documentation and preparation efforts banks have to undertake when launching covered bonds. Finally, it allows investors to grasp the individual characteristics of covered bonds relatively easily and thus limits time spent analysing their credit quality and value.

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Collateral assets

Apart from their pure quality, collateral assets have to meet further requirements. Only performing assets are eligible as collateral. This is to avoid potential dilution of the quality of the cover pool. Moreover, the cover pool is frequently reviewed to maintain its quality and any assets that no longer qualify are replaced.

In addition, the structure of these underlying assets has to match that of the outstanding bonds with regard to the currency denomination, outstanding amount, interest payments and maturity. Hence, the possible degree of mismatches is limited. The increasing use of derivatives has helped issuers to meet these requirements.

Overall, the matching and performance restrictions together with the different term structures of asset cover pools and outstanding bonds require management of the collateral pool to be a dynamic rather than a static process. While this adds to the quality of the bonds issued it also allows issuers to actively manage and service their on-balance sheet loan portfolio.

Bankruptcy remoteness

Further attractions of covered bonds are their high degree of bankruptcy remoteness and the post-bankruptcy procedures of most jurisdictions. In the event of bankruptcy of an issuer, covered bonds would not accelerate. Instead, the bonds and the corresponding cover assets would be removed from the balance sheet of the bankrupt estate. Both portfolios would thus lose their dynamic nature. They would then be run as a separate fund for as long as the collateral pool is solvent and there remained outstanding covered bonds.

During this period, covered bondholders have a legally enshrined priority claim on the collateral pool. Unsecured creditors of the bankrupt entity do not have access to the collateral assets prior to the last covered bond being fully redeemed. In addition, should the collateral pool become insolvent during this post-bankruptcy period, any unsatisfied claims of covered bondholders would usually rank equally with the unsecured creditors of the bankrupt issuer.

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Credit rating issues

Due to their security features, the ratings of covered bonds have tended to achieve better levels than unsecured debt of the issuer. The implementation of a variety of self-restrictions and the provision of a degree of over-collateralisation also allows issuers to directly influence the rating obtained. Depending on the approach employed by the rating agencies, covered bonds can achieve ratings that are between one to possibly eight notches above the issuer’s counterparty rating or can even be completely de-linked from the latter.

This uplift is irrespective of the maturity of the bonds. Consequently the vast majority of covered bonds currently outstanding are double-A or triple-A rated. This high rating, combined with the 10% to 20% risk weighting for these bonds, naturally leads to very attractive funding levels. Indeed, on a swap-spread basis, covered bonds are trading well below both unsecured bank debt and off-balance sheet securitisations.

Investor confidence in covered bonds is based on their high rating and their high degree of security as demonstrated by the fact that no covered bond has ever defaulted in over 100 years. This has also helped covered bonds to become the largest outstanding debt category within European bond markets.

Jumbo issuance

Until around nine years ago covered bonds were typically small in size and targeted at domestic markets. However, rising public sector and mortgage indebtedness, increasing internationalisation of capital markets and the introduction of the euro, has encouraged European banks to search for a far broader investor base.

The key prerequisite was the ability to launch covered bonds on an individually larger-sized, and thus more liquid, basis. Starting in Germany in 1995, this triggered the issuance of the first so-called Jumbo covered bonds. These bonds are non-callable bullet bonds with a fixed coupon and typically reach issue sizes of E1bn-E5bn. Such bonds are issued with a maturity of two to 20 years and are broadly distributed in European and other investor markets.

Due to a special market maker system, Jumbos and similar benchmark bonds are actively traded in the secondary market with bid-offer spreads usually being no more than two basis points. Growth has been fast; more than 50% of the total outstanding volume of covered bonds in Europe are Jumbos or highly liquid benchmark bonds with a outstanding volume of around E1bn or more.

Structured covered bonds

The first stage in the development of the market for covered bonds has been an overwhelming success. The concept has been particularly attractive to banks in several European countries where a domestic legal framework for covered bonds is already in place. The second stage saw several European countries, such as France or Luxembourg, without a framework in place, or with a framework lacking specific security features, implementing or starting to implement the necessary legal requirements to allow their banking industry to participate in this growing market.

A key turning point in the development of the covered bond market was change in the analytical approach of the rating agencies. These changes provided the scope to analyse and to rate so-called “structured” covered bonds in the same manner as ordinary covered bonds. To begin with, structured covered bonds were viewed as bonds where, in addition to existing regulations and legal requirements, issuers enhanced the credit quality via contractually added structured finance elements. In stage two, this process led to the creation of covered bond systems which solely consisted of contractual, common or civil law based structures replicating those systems that were set up under a specific legal framework.

The implementation of these second stage formats during 2003 has triggered an enormous momentum in the banking industry in favour of covered bond systems in general. The dynamic of this process is widely expected to expand further into countries outside Europe such as Australia.

Regulatory changes

An important point to note is that covered bonds fit well under both the current and the new regulatory regimes. Indeed, the bonds are ready to meet the changes arising from IAS 39 and Basel II. Under Basel II, some risk weighting requirements, in particular for residential mortgage loans, are scheduled to decline from currently 50% to at most 20%. This will reduce the need to fund these assets off-balance sheet due to the significantly lower capital costs, although, as is shown in the case study on page17, this is dependent upon the capital and funding mix applied by the originating bank.

At the same time, IAS 39 will make it more difficult to take assets off-balance sheet, requiring possible re-consolidation in some cases. Therefore, covered bonds are becoming a more attractive funding alternative to traditional off-balance sheet securitisation for vanilla assets. The assets remain on the balance sheet and pure funding costs are lower. Based on these advantages it is possible that banks will seek over time to use other high quality assets, in addition to mortgages and public debt, as collateral for covered bonds.

Future issuance

The success of a structured covered bond system will be determined by two major components: first, the political and economic structure the issuing bank is working within; and secondly, the degree of standardisation and homogeneity the respective covered bonds will offer.

A covered bond issuer needs the political, economic and legal system of the country in which it operates to be both stable and reliable. Aside from the pure enforceability of the contract, these factors are also the basis for the low risk characteristics of collateral assets such as mortgages. For the foreseeable future it seems unlikely that covered bonds systems will be started in those countries with real estate markets that lack the depth and relatively limited price volatility of western European countries.

Investor and issuer synergies

Covered bonds typically offer limited additional return versus government bonds or swaps. Hence, investors are only willing to buy covered bonds where they have sufficient size as to be liquid and/or require limited analytical efforts. This is only achievable in practice if a single bank commits to repeat issuance under a single covered bond structure rather than numerous derivatives.

Ideally, the covered bond structures used by issuers based in the same country should only diverge to a limited degree. If future issuance does not address these points, then the structured covered bond market runs the risk that it will end up as a fragmented and illiquid market and thus possibly offering less favourable funding levels.

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What next?

In the years ahead, we expect an increasing volume of new issuers and markets developing the capabilities and infrastructure for covered bonds. New European markets such as Belgium, Italy, Norway, The Netherlands and Portugal will continue to be almost exclusively based on specialised existing covered bond laws.

In contrast, those yet to be started in other jurisdictions are more likely to be based on fully structured covered bonds. By meeting the essential economic prerequisites and characteristics of the current operational covered bond markets, investors are likely to welcome new markets. New covered bond markets and issuers will help to improve both the return and liquidity of portfolios and new markets will offer investors an enhanced degree of asset diversification while requiring only a limited degree of additional analytical effort.

Christoph Anhamm is senior covered bond analyst at ABN AMRO

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