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AmericasApril 1 2007

On the bandwagon

Covered bond issuance out of the US will not only widen the global market, but also deepen the investor base for the European issuers, writes Michael Marray.
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The arrival of US issuers represents a major shift for the global covered bond market, both in terms of the likely effect on total supply in the coming years and the deepening of the domestic US investor base for European issuers.

The first ever deal came from Washington Mutual last September, with a €4bn offering lead managed by ABN AMRO, Barclays Capital and Deutsche Bank. In mid-March, the second transaction out of the US was being roadshowed across Europe: Bank of America also decided to issue in euros, in a deal lead managed by ABN AMRO, Deutsche Bank and Bank of America Securities.

According to one analyst at an investment bank, up to five more US banks have signalled interest in doing transactions and some of them are likely to hit the market during 2007.

Martin Kennedy, credit analyst at Standard & Poor’s in New York, says: “Our current expectations are that the new entrants in the market will initially be fairly well-capitalised financial institutions, using the technology as a cost-effective alternative to financing through the Federal Home Loan Bank (FHLB) or the Government Sponsored Entities (GSEs).

“Covered bond issuance may also increase as the Basel II risk-based pricing rules are implemented, which may make on-balance sheet financing more economical in the coming years.”

The arrival of US issuers is not just significant for US banks looking for a new source of funding. It will also help to stimulate the domestic investor base, which means that there should be a growing volume of dollar issuance from European issuers into the US.

There is a well-established pattern in the covered bond market, in which domestic investors feel obliged to look at covered bond offerings from institutions in their own country. For many, this will be the first time that they look at the covered bond asset class and understand the underlying structure. But once they have bought into the first few offerings from domestic institutions, they then start to look at products from other countries.

Investor base opens up

“US institutional investors will buy in size once they are convinced about covered bonds as an asset class. The arrival of US issuers such as Washington Mutual and Bank of America is helping this process of familiarising US investors with the product,” says Armin Peter, head of covered bond syndicate at UBS in London.

“European borrowers are now keen on stepping into that investor base, as HBOS did with its first US dollar deal last November, and there is an expectation that we will see a growing number of dollar deals from European banks,” he adds.

The US investors base is likely to favour the largest, most liquid deals from banks with very big mortgage portfolios, which are likely to become repeat issuers in a variety of tenors. “Liquidity is important to investors, who like the fact that on jumbo deals there are market makers quoting two-way prices for the street, and not just for their own clients,” says Mr Peter. “This ensures liquidity at all times, and in such a deep and liquid market investors can easily trade tickets of €100m or u200m, which may be more difficult in other fixed income asset classes.”

Ted Lord, head of covered bonds at Barclays Capital in Frankfurt, says: “There are compelling reasons for European covered bond issuers to develop an American investor base with dollar-targeted transactions. The more widespread and greater the investor demand, the better spreads an issuer can achieve. Most of the US investor-targeted benchmarks should come from those issuers with large funding needs. The American investors seek large, liquid benchmarks and a fully developed curve. This will be especially important for those US investors that would view covered bonds an as alternative investment to US treasuries or US agency paper.”

Big names are attractive

In addition, global investors such as central banks are likely to be interested in both dollar and euro offerings from well-known US institutions, in a market where name recognition is important.

“Asian investors are continuing to grow as an investor group in the covered bond asset class,” says Mr Lord. “The euro has proved to be a stable-to-strong currency, and some Asian countries have greater exports to the EU than to the US. Asian investors have large US dollar liquidity and should be increasingly present in US dollar bond issuance.”

Dollar issuance will be the logical next step for US issuers, although for their debut offerings both Washington Mutual and Bank of America elected to issue into the euro-denominated market, where many of the most active European covered bond investors are most active.

In the groundbreaking Washington Mutual deal, the bonds are issued by WM Covered Bond Program, a special purpose entity which purchases floating rate US dollar-denominated mortgage bonds issued directly by Washington Mutual Bank. The programme then engages in a cross-currency swap, providing investors with a fixed-rate euro-denominated security. For the debut offering, investors bought €2bn worth of five-year bonds and €2bn worth of 10-year bonds.

Depth and liquidity

Commenting on last September’s offering, Washington Mutual chairman and CEO Kerry Killinger said the depth and liquidity that the European covered bond market offered were compelling because the company considered alternative funding sources. It planned to be a regular issuer in the market to complement its other borrowings in the US, he said. It collaborated with the US Federal Deposit Insurance Corporation and the Office of Thrift Supervision in developing its European covered bond programme.

“This programme should make our debt more sought after on a global basis, ultimately reducing our company’s cost of funds, as well as increasing our investor base beyond the US,” said Mr Killinger, noting that Washington Mutual also successfully issued a €1.5bn five-year unsecured bond last August.

Ironically, analysts note that the Washington Mutual covered bonds widened out by a couple of basis points last month, with investor sentiment impacted by the US sub-prime market.

The US sub-prime lending market has been the focus of a stream of bad news this year, with bankruptcies among sub-prime lenders, profits warnings (including one from HSBC because of its US sub-prime mortgage portfolio) and volatility in the subordinated BBB tranches of US sub-prime mortgage securitisations.

All this background noise should in theory have little to do with Washington Mutual, which is a strong prime mortgage lender and whose covered bonds are backed by prime first lien mortgages. Holders of its covered bonds are looking first to its full recourse obligations to repay them, and only in the event of a failure to repay would the underlying mortgage collateral be called upon.

Nevertheless, the bonds were still a sell for some investors. “It shows that the covered bond market remains somewhat susceptible to headline risk,” says one analyst.

Ted Lord: the Asian investor group is growing

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