Traditionally a low-risk area, the European covered bond market is now a much more volatile place. Philip Alexander explains how Portugal fits into the wider European picture.

Until mid-2007, European covered bonds were an asset of choice among investors with a low-risk appetite, both institutional and retail. However, the asset class did not escape the wider market chaos, because lower financial sector liquidity and fears about the underlying credit quality of mortgage pools provoked sometimes extreme volatility. By the end of 2007, almost all European mortgage covered bond issues had been affected but some were still comparatively stable or had resisted the turbulence for longer.

German and French issuers benefited from long-established markets and a large domestic bid, which was easier to sustain during tough times.

High volatility

By contrast, Portuguese banks are newer entrants with a smaller home market. “Those markets that have joined relatively late in the game have shown higher volatility and that links with the more limited time they have had to cultivate a known investor base,” says Heiko Langer, senior covered bonds analyst for BNP Paribas in London. With electronic trading not yet introduced and few reliable means of hedging the asset class, market-makers grew increasingly anxious about possible losses on non-core covered bonds and stopped providing continuous quotes for some issues. In response, the European Covered Bond Council agreed, in January 2008, that market-makers could triple bid/offer spreads for bonds trading more than 20 basis points (bp) over mid-swaps.

Market impact

This decision has affected the Portuguese market significantly. “Across the whole curve, Portuguese covered bonds are generally trading at more than 20bp, so they would mainly fall into that higher-spread category,” says Mr Langer.

Of course, markets are never entirely rational and some of the sentiment affecting Portugal has little to do with fundamentals. “There has been a bit of an Iberian effect, because the Spanish cedulas market was one of the first to suffer, and I could imagine that some investors made a link between the two markets for geographical reasons,” says one market participant. The articles in this guide therefore ­provide a timely opportunity to examine the Portuguese covered bond market in a more discerning way, shedding greater light on its distinct credit quality and ­legislative framework. n

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