Covered bonds will continue to grow healthily into 2007, thanks to newcomers and new regulations, despite issuance slowing in some markets. The introduction of new regulations in Denmark and Norway, as well as the successful entrance of Portugal's big bank Millennium and Bank of America to the European covered bond market, has bolstered some variety in issuance trends. But issuance in both Germany and Spain - Europe's biggest covered bonds issuers - continues to cool, say market sources.
Dresdner Kleinwort Wasserstein reports that projected outstanding covered bond volume is projected to run 900 million, up from 750 million in 2006. Jumbo issuance volume is also expected to increase, to 210 million this year, compared with 180 million in 2006. And new legislation in Norway and Denmark should help to build volume expectations further this year. The new covered bonds legislation passed by the Danish parliament last week will enable commercial banks to issue covered bonds, whereas prior to the new law, only specialized mortgage credit institutions could issue mortgage covered bonds. Norway also passed similar laws.
"A possible entrance of Denmark and Norway into the jumbo covered bond market would further strengthen the internationalization of covered bonds," said Annegret Hasler, a covered bond analyst at Dresdner Kleinwort. To be sure, more countries continue to explore the possibility of structuring legislation that facilitates a covered bond market. According to market reports, Turkey, Croatia and Slovenia are working toward setting up a legislative framework to support covered bond issuance.
From across the pond, Bank of America entered the covered bond market after Washington Mutual became the first U.S. issuer last year. BofA's deal was sold in two tranches of five and 10 years, each worth 2 billion. The arrival of U.S. issuers, sources say, will continue to shake up the German and Spanish-dominated market and may cause a change in the investor base.
This shifting landscape is prompting rating agencies to review their methodologies. Helene Heberlein, managing director of covered bonds at Fitch Ratings, said that the changes in European covered bonds has led Fitch to roll out a new methodology, which relies on the new concept of the discontinuity factor (D-Factor). Heberlein explained that the D-factor assesses how the probability of default on covered bonds can vary from the probability of default by the issuer. "The D-factor addresses the question of whether covered bond payments could continue despite the insolvency of the issuing entity," said Heberlein. "Rather than giving a yes' or no' answer, the agency identifies a range of variables that would have an influence, such as the strength of asset segregation, the provision for an alternative management in insolvency, the solution to potential liquidity gaps and the role of the oversight."
So far, out of 61 covered pools backing covered bonds rated by Fitch, 11 have been assigned a D-factor.
But despite new entrants to the market, the more established sectors are beginning to see a slowdown in issuance. Spanish covered bond issuance was expected to exceed 50 billion, based on increased mortgage lending. The cooling of the residential mortgage market means that banks have been slower to tap the market. Half way into the year and volumes stand at 4bn ($5.35) in Spain
The German market has also shrunk on the back of a sharp reduction in the supply of public-sector assets. German covered bond issuance was around 40 billion at the end of 2006, 60% lower than the 110 billion issued at the market's peak in 1999. Some market players are more optimistic, believing issuance will pick up in the second half of this year bolstered by unguaranteed Landesbank Pfandbriefe. "The shrinking liquidity cushion built before the abolition of the state guarantees in July 2005 is likely to set off issuance towards the end of the year," said a Commerzbank report issued earlier in the year. "In addition, the issuance of mortgage Pfandbrief is likely to increase significantly as soon as the rating agencies accept mortgages on the balance sheets of the savings banks as insolvency remote cover for mortgage Pfandbrief issued by Landesbank. This can be achieved via the entry into the refinancing register."
RMBS Still Offers Its
Own Appeal
Covered bonds offer a cheap method of funding, but securitization still holds appeal for buyers. Suzanne Albers, senior director in Fitch's covered bonds team, said that ABS tend to be floating-rate pass-through notes, while covered bonds are usually fixed rate and have bullet maturities. Thus each attracts a different investor base.
"Covered bonds are primarily a triple-A market," Albers said. "Triple-A securitization investors may want to consider covered bonds if they are interested in the payment profile, but they are unlikely to get a better yield."
Despite the different characteristics, Dresdner's Hasler is confident about future performance. She believes that covered bonds will remain attractive to investors, especially as the issuer landscape differentiates more and more. "There are certain advantages of covered bonds compared to MBS/ABS, like liquidity, stereo product, market making, etc., where covered bonds will always be ahead of MBS," Hasler said.
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