The European covered bond market has taken some steps forward despite the economic environment. The pipeline has seen fresh issuance while new markets have opened supported by new legislation.
Despite these inroads, the sector finds itself on shaky ground, a factor that could rattle investor confidence.
The security offered by covered bonds even in the most developed markets, such as the German Pfandbrief sector, has disappeared.
A rising number of triple-A ratings have primarily become dependent on a high level of overcollateralization rather than being based on the asset pool's inherent credit strength and the covered bond legislation's quality.
The next wave of write-offs is in the cards. Although governments are taking counter-measures and are expanding their support programs, investors are likely to remain cautious as long as there is a risk of individual issuers coming under pressure as a result of negative headlines. "A large name-specific risk requires investors to keep their focus on conservative issuers and product selection," Ted Packmohr, a covered bond analyst from Dresdner Kleinwort said. "The market's focus on names with ties to the public sector therefore comes as no surprise."
However, over the short term, the reality is that the European covered bond market will have to compete with the state guarantee for a bank's bond issuance. Deal volume has already felt the same pressure European ABS has faced because primary offerings have generally been retained for central bank funding purposes.
A market source said that, at least in Germany, the percentage of deals going directly to the European Central Bank (ECB) for repo purposes has stayed at less than 50%, which means that German Pfandbrief is doing well - at least better than other markets.
Packmohr said that the primary market is mainly driven by state-guaranteed bank bonds, agencies and the govy/Lander (Swiss government bonds/German national bonds) segment. "Although demand seems to have somewhat cooled down here as well, the fact that many guaranteed papers have displayed a strong performance during their initial days of secondary trading has left a positive undertone," Packmohr said. "Issuance spreads thus appear sufficiently attractive, and ongoing high volumes could be placed successfully without pricing levels drifting farther apart."
The German government recently announced that it is preparing an extension of the maturity window for state-guaranteed bonds from three to five years within a forthcoming amendment to the Financial Market Stabilization Act. The Association of German Pfandbrief Banks (vdp) warned that this will be detrimental to Pfandbrief sales and, therefore, damaging for the market.
The issuance pattern over recent months indicates that state-guaranteed papers are the main focus of investor interest and are exerting significant competitive pressure on alternative types of bonds, the more so given that demand has for some time been concentrated in the short to medium maturity segment, Packmohr said.
"This means there is already limited scope for covered bonds to escape competition from guaranteed papers through longer-dated public placements," he said. "Until now the five-year segment offered the best middle way in this respect and was therefore used by both Landesbank Baden-Wurttemberg and Deutsche Postbank for their Jumbo ventures."
The vdp is concerned that extending the term of guaranteed papers will place them in competition with the Pfandbrief for this territory too. "State guarantees might be prolonged, and this will harm covered bonds, but there is no other choice because at the moment banks need this alternative," said Sascha Kullig, head of capital markets at the Association of German Pfandbrief Banks and a speaker at Information Management Network's annual covered bonds gathering in London.
Bracing for a New Blow
Standard & Poor's this year announced that it will be placing much more emphasis on the issuer credit quality.
"Depending on the liquidity risk, which currently dominates the market headlines, S&P is now dividing covered bonds into three quality categories," Packmohr said. "The greater the risk of a liquidity bottleneck following issuer bankruptcy, the stronger the linkage of the covered bond rating to the bank's credit quality."
Factors that determine this liquidity risk of the pool are, among others, asset-liability mismatches, the cushion in the form of (ECB-eligible) liquid replacement assets, access to third-party liquidity facilities as well as the systemic importance of the respective covered bond product in the domestic market.
While category one covered bonds can continue to achieve a triple-A despite the issuer rating, this will be, generally speaking, possible for category two securities only if the issuer has at least a single-A rating. Packmohr said this is likely to affect German Pfandbrief as well as the issues of German subsidiaries in Ireland or Luxembourg, French Obligations Foncieres and Danish covered bonds.
If a covered bond falls into the weakest category, like Sweden, it will typically require an issuer rating of at least double-A-minus to secure a triple-A rating.
S&P states that approximately 60% of the covered bond programs it rates would not meet its new 'AAA' requirements and could come under rating pressure. The agency at the same time also wants to significantly raise its evaluation haircuts applied to assets within forced-sell stress scenarios, and as a result many programs may also face considerably higher overcollateralization needs.
"In the case of U.K. covered bonds, for example, the agency predicts an increase in overcollateralization requirements from around 11% to more than 40%," Packmohr said. "As a result, there are a large number of covered bonds overall in danger of losing their 'AAA' rating from S&P."
Issuer feedback hasn't been favorable, but from an investor's point of view, the review of S&P's rating approach was welcomed. "We are not opposed to S&P opinions; addressing liquidity risks has become more important," Kullig said. "We do object to the way S&P wants to do it." He added that the changes bring too many contradictions and the approach is still far away from being a consistent proposal.
Fitch Ratings said it is also reviewing its procedures to evaluate liquidity risks as part of its covered bond analysis.
Covered bond ratings will be more closely tied to the issuer quality, overcollateralization requirements will rise and several issuers are likely to lose their 'AAA' ratings.
"It is disappointing how agencies have seemingly missed the point," said Horst Bertram, head of investor relations at Bayerische Landesbank. "And the lack of understanding is frustrating, not to mention that the quality of work is confusing." Bertarm believes that as conditions tighten in the ratings space, the industry could respond by developing alternatives to having three ratings via a more transparent platform, a neutral point of information that would save both issuers and investors money.
However, Packmohr points out that unlike the changes S&P proposed, the adjustments by Fitch do not represent a fundamental change in its current valuation methodology for covered bonds. "The agency thus remains true to its current approach, according to which the rating of a covered bond is determined in three main steps," he said.
Deals Continue to Filter Through
But even with the prospect of less attractive pricing, issuers are heeding investor concerns and getting deals done. The benchmark for spreads has slid upwards.
According to Bertram, Pfandbriefs are still cheaper to structure and do not require the high fees charged for government funds. "We don't need these guaranteed bonds lasting forever, and when the markets get more stable then investors and issuers will turn to covered bonds as the more traditional product," Bertram said.
LBBW issued the first Jumbo Pfandbrief of the year. The pricing level of the five-year paper was 75 basis points over swaps, which took into account the continuing spread pressure in the market and resulted in very rapid book building.
"A year ago the bank was able to place an equivalent bond at -1 basis point," Packmohr said. "Yet only two weeks ago L-Bank, the development bank for the federal state of Baden-W¸rttemberg, placed a five-year paper at 45 basis points, and primary spreads have widened further since."
Deutsche Bank also plans to tap the monetary advantages of secured funding by issuing mortgage Pfandbrief.
The early January 2009 pricing of BNP Paribas' E1.5 billion ($1.97 billion) triple-A-rated Jumbo covered bond came as something of a surprise. It signaled that, for the right price, investors are still willing to put money to work. It was the first Jumbo covered bond since the collapse of Lehman Brothers in September. The deal had a five-year maturity, carries a coupon of 4.125% and was launched at mid-swaps plus 110 basis points through three bookrunners: Commerzbank, Danske Bank and Royal Bank of Scotland.
Soon after, Credit Agricole's new subsidiary Credit Agricole Covered Bonds was in the market with its first covered bond issue. The issue is worth E1.25 billion with a seven-year maturity. The annual coupon is fixed at 4.5% equal to the swap rate for the same maturity at 135 basis points over Euribor.
"Compared to senior unsecured levels, the market is still pricing comparatively cheap," Kullig said.
The market believes that the growing need for regulated financial instruments puts Jumbo issuance at a particular advantage since the instrument is heavily regulated. The demand for simpler structures can also be satiated in the covered bonds sector, where products are less complicated and the products also offer the much sought-after transparency that investors demand in this challenging environment. "There is a clear commitment from governments to do everything they can to ensure no defaults in the future," Kullig said.
Covered bond issuance on the private side has seen a pickup in activity. Andreas Denger, a senior portfolio manager in fixed income at Meag Munich Ergo Asset Management who spoke at the IMN event, estimated that in Germany, two-thirds of covered bond issuance has been done via private placements. "There is a big advantage for issuers to do deals privately because they don't have to value mark-to-market and the high volatility of repricing is avoided," Denger said.
Ironically, international take-up of the instruments has proved much higher than in better times, said Bayerische's Bertram. He added that it provided a testament to the soundness and viability of the product over the longer term. "There is still a lack of long maturity; it's a challenge because we would like to get that longer maturity," he said.
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