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Western EuropeNovember 4 2004

Explosive issue

Demand for covered bonds is rocketing, as the Bank of Ireland recently discovered. 
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In the space of three and half hours, interested investors pledged €7.2bn for the Bank of Ireland’s first covered bond, according to an insider. Officials were ecstatic: not only was it their first crack at such an issue, but it had been received enthusiastically by international financial players and over-subscribed by three and a half times.

The deal, in September was a confirmation of something the sector has been aware of for a few years; covered bonds are hot. Their issuance is exploding and there is interest in the product across a broad range of investors, from central banks, through pension funds, right down to high-net-worth individuals.

According to ABN AMRO, next year’s gross supply of European ‘jumbo’ covered bonds should reach €125bn with one-third of that coming from Germany. It is regarded as a healthy figure by players in the market, although not as healthy as the German financial markets could have expected in the past.

German dependence

The covered-bond market has long been regarded as a German speciality. The jumbo pfandbriefe (an issuance in excess of €1bn) appeared in 1995, long after the concept’s first appearance during the Austrian succession wars of the 1700s. Then, the farmers got loans needed to keep their holdings alive by using agricultural land as collateral.

“This growing market is less Germany-dependent although the pfandbriefe has been regarded as its foundation,” observes Raimon Royo, a director with Fitch rating’s covered-bond team.

And the Irish deal is a story that reflects the changing fortunes of the covered bond market. At its most simple, a covered bond is a debt instrument secured by mortgage assets and/or public-sector debt. They are issued by financial institutions and about 95% of them receive a AAA rating. The ratings are based on the strengths of the underlying assets relative to the unsecured debt of the issuer.

Law introduction

In the Bank of Ireland case, as with all issuance except that of the UK, the terms are laid out by law. “The introduction of these laws have helped develop some sort of European market and as each new law has been introduced there’s increasingly been ‘best practice’,” explains Xavier Baraton, global head of at HSBC Asset Management in Paris.

Yet while it was the first Irish mortgage-backed bond, both German-based Depfa Bank and West LB had already launched asset-backed bonds using Irish legislation. These two banks also reflected Germany’s supremacy of the covered-bonds market until 1999. Although Denmark, Switzerland and Austria had quasi-covered bonds, they played little part in the market.

Even though Germany has issued 69% of the total current outstanding covered bonds, its market dominance has been forever dented. HypoVereinsbank figures show that in the first quarter of 2002, Germany issued just over €25bn. That fell to €16bn by the first quarter of 2003 and remained stable into this year’s first quarter. By comparison, issuance of Spanish cedulas in the first quarter of 2002 was under €4bn. The same quarter in 2004 saw it issue over €8bn.

“The covered-bond market really started in 1995 with the jumbo pfandbriefe and for some time they were the only article and seen as a challenger to the securitisation market,” observes Mr Baraton.

Pfandbriefe role

The role of the pfandbriefe has diminished over the past three years. “It brought liquidity to the market by jumbo issues having to be over E1bn, but there were credit concerns to be addressed about the German market and it was pushed to amend its framework,” explains Christoph Anhamm, senior covered bond analyst with ABN AMRO. “Another trigger had been the German banking crisis,” he adds.

The EU forced the abolition of state guarantees for German Landesbanken, the biggest issuers of pfandbriefe.

“From 1999, new laws were created in Luxembourg and France which crept into the market and then there was Spain,” says Mr Baraton.

“The largest growth rate in the market we’ve seen, and will see, is Spain,” says Mr Anhamm. Until five years ago, Spain did not use the covered bond market but, as legislation was introduced, mortgage demand exploded. By using the covered-bond structure, the banks found their mortgage debt was lessened.

The size of the issues made liquidity less of an issue and institutions, among others, found them attractive. “There was less top-rated sovereign debt on the market in the last few years and these were regarded as a safe product,” says Mr Royo.

In the days of massive asset reallocation to safer products, these triple-A rated products offered low risk. “Today, covered bonds are trading at a spread of roughly between 17 and 20 basis points over German bunds. In 2000, this was a lot bigger, as much as 55 basis points,” explains Achim Linsenmaier, a vice-president of Deutsche Bank’s covered bonds syndicate based in Frankfurt.

 

 Achim Linsenmaier, vice-president of Deutsche Bank’s covered bonds syndicate 

“At the moment – in this low-yield environment – everyone is yield hungry and people are willing to move slightly down the ratings curve in order to lock in higher spreads” he argues.

Mr Linsenmaier adds: “For many accounts, jumbo covered bonds have become an attractive alternative to government bonds over the last few years, as these offer a spread pick-up over government bonds and also include a market-making feature, which guarantees liquidity for investors. This makes them an interesting investment for insurance companies, bank treasuries, central banks and all types of funds. The growing demand has also generated new supply. Many new issuers are looking at this market and it’s attractive refinancing opportunities with the UK-issuers having had their debut last year. This year, Italy looks likely to follow and others are lining up.

ABN AMRO’s Mr Anhamm says: “The classic argument to attract a large part of the investor community is that they are benchmark-biased, leaning heavily on government debt and now you can buy via the market making system a plus spread above the benchmark.” But, he warns, those spreads are shrinking.

Europe dominates

However, demand has become widespread, although it is mainly a European game. “US investors do not play a very important role. They might purchase up to 5% of an issue but usually their participation is below 1%,” ventures Mr Linsenmaier. He adds that this might change should US hedge funds take a greater interest in the instrument, but there little indication of that yet. “The US real money accounts remain mainly focused on the big US agencies.” he says.

While figures differ between issues, Mr Linsenmaier has some idea of the sort of buyers that come to the buying desk. “It typically depends on maturity, but say an average well-rated 10-year bond came to market, 5%-10% would be bought by insurance companies, 30%-35% by fund managers, 5%-10% by central banks, 20% by pension funds and 30%-40% by banks.”

“We’ve seen a lot of interest, in particular from Asian central banks seeking to diversify their investments but remaining very conservative,” observes Mr Royo.

Peculiarly, the UK now makes up 2.4% of the outstanding issued market, but then, the first covered bond was only issued last year by HBOS. What makes it peculiar is that the UK is the only international player that uses complex contractual law to structure the product, rather than legislation. The bonds remain highly regarded, but it is bucking the trend.

Germany is due to change yet more legislation next July, enabling all German banks to issue covered bonds. “In the last year or so, Germany has taken back part of the market and can achieve good ratings,” says Mr Anhamm.

Legislation change

But there is a raft of legislation yet to come. Italy and Portugal are to introduce covered bond legislation next year, with Sweden modifying its own. “Italy could bring a large mortgage book to the table, on a par with Spain,” comments HSBC’s Mr Baraton. And as in Germany, partly for tax reasons, retail purchase is a reality in Italy.

But the biggest change likely to benefit the covered bonds market will be Basel II. It sets out to bring banks’ capital requirements into closer alignment with the economic risk of holding different financial products, effectively meaning the new rules will be negative for equity and positive for fixed-income products.

“It will allow a lower risk rating for mortgages and will be less attractive to fund off-balance sheet – all making covered bonds more attractive to issue,” says Mr Anhamm.

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