Covered bonds have been around for many years but the investor base has traditionally been relatively exclusive. Recently this has changed, as investors outside Germany, and from an expanding array of institutions, have caught on to the appeal of these low-risk securities. But will it be enough to offset the withdrawal of the ECB’s buying programme? Savita Iyer reports.
Talk to any covered bond expert and they will tell you that the asset class is inexorably linked to Germany and the German investor base. During the worst of the financial market crisis in 2009, German investors – banks, funds and insurance companies – were instrumental in supporting the covered bond market. So far in 2010, sources say, German investors have bought close to 50% of all the covered bonds issued in Europe.
Germany has a long covered bond history. More than any other, the German investor is extremely familiar with the product, said Leef Dierks, vice president and covered bond analyst at Barclays Capital. As the supply of German Pfandbriefe has started to dry up (German covered bond issuers simply do not need as much funding as they once did), German investors have had to look elsewhere for their covered bond paper.
Quality gap
But even if they are committed to the covered bond market generally, German investors have expressed a clear preference for paper issued from certain jurisdictions. And the quality gap is likely to become even more pronounced in the aftermath of the Greek crisis, said Dierks, as the covered bond market starts to pick up again. It is likely to lead investors to favour core jurisdictions: Germany itself, France, the Nordic region and the UK. Spain and Portugal, which, despite good fundamentals, are being held hostage by what’s happening on the sovereign side, are likely to lose out, Dierks said.
“It will be tough for Spanish and Portugese issuers in the primary market to find buyers even though they will have to offer higher premiums for their paper,” Dierks said. “On the secondary side of the market, flows are definitely less, because investors are in a wait-and-see mode, since it’s still unclear how the situation in Spain would develop.”
But the sovereign story is unlikely to have any lasting impact upon the covered bond market, Dierks said. While issuance came to a complete standstill at the end of April, there are signs that the market may be opening up again. More importantly, there are a large number of issuers just waiting to tap it.
And as these issues start to come, investors will be waiting. Despite some initial fears of systemic risk, investors are aware that the premiums covered bonds offer compared to sovereign bonds are attractive, said Ralf Grossmann, head of covered bond origination at Societe Generale in London. French and German government bonds, for example, have outperformed and tightened a great deal as investors have fled to quality, but covered bonds from both countries offer at least 60 basis points spread over their sovereigns, he said.
“You get a nice pick-up and good carry over sovereigns, and there is a huge amount of cash out there that investors will want to put to work,” Grossmann said. “The recent turmoil didn’t happen because of the financial industry. It came about from the sovereigns, not from covered bond issuers, so investors are still confident about the product and are attracted by the pick-up over sovereigns.”
The perception of safety associated with covered bonds is what helped revive the market in 2009. At that time, investors like hedge funds, which had never really considered covered bonds before, were attracted to the fact that these Triple A-rated instruments were trading at such wide spreads, said Frank Will, senior strategist for frequent borrowers at RBS in London. They piled in en masse alongside dedicated investors. Spreads, spurred by the European Central Bank’s announcement of a €60bn purchase program for covered bonds, tightened in.
Everyone’s best friend
“Suddenly, there were more buyers and everyone was jumping on covered bonds,” Will said. “That encouraged more issuance and over the past year, we have had a major increase in issuers, with the covered bond becoming a major funding tool for European banks.”
Covered bond spreads have widened as a result of the sovereign crisis, but not as much as in 2009, so they don’t offer the same opportunity as they did in 2009, according to Dierks. Hedge funds have, for the most part, retreated from the market, and are not likely to find it interesting enough to come back. Banks, insurance companies, pension funds and central banks in different European countries, on the other hand, remain keen buyers. When the market gets going again, these investors will provide sufficient liquidity to support it.
Banks are the backbone of the covered bond market in Europe, something that is unlikely to change. But over the past year, there has been a noticeable change in the composition of the investor base for covered bonds. New funds have been especially set up to buy covered bonds, particularly in Germany, while a greater number of pension funds and insurance companies are active in the market than used to be.
“Before last year’s crisis, central banks and dedicated funds were the core buyers for covered bonds,” said Will. “But our order book shows a much broader investor base now, with people putting in more and diversifying their covered bond portfolios more according to different product type and maturity.”
Most industry observers believe the covered bond market has enough momentum to keep going, albeit a bit slower pace, despite the sovereign crisis. But the one spanner in the works right now is the termination of the ECB purchase programme. While there is probably sufficient liquidity to support the covered bond market right now, experts agree the market will probably feel the end of the programme more than it would have if the sovereign crisis had not happened.
The ECB purchase scheme was a positive for covered bonds, said Massimo Catizone, senior credit officer at Moody’s Investors Service. There is some consensus that it was instrumental in kick-starting both the primary and secondary markets after the peak of the financial crisis. The big question now is how the weakening credit and fiscal environment in a number of EU countries will affect covered bond liquidity, particularly in light of the imminent conclusion of the ECB purchase scheme and the potential for a spill over from the sovereign problem.
Covered bond investors are therefore more likely to focus on asset quality and the creditworthiness of issuers, and consider issuers that are domiciled in countries with stronger economies. “The strength and creditworthiness of an issuer, as well as the quality of their underlying pool of assets, are some of the factors that will determine how they manage to place their issues,” Catizone said.
The ECB had been buying an average of €5bn worth of covered bonds a month, said Dierks, a loss the market will surely feel. However, there are enough investors interested in covered bonds, despite a probable drying up of liquidity in the near-term.
Investors who support the covered bond market will have one thorn to contend with: shadow book building, has long been a practise that has caused consternation among investors. The practice – whereby syndicates soft sound the market to get a sense of the potential demand for an issue and where it should price – gained momentum in 2008 and 2009, quickly becoming commonplace.
Smaller investors have been particularly unhappy. “They feel that the bigger guys are always approached by the syndicates, that they don’t have time to look over the issues and the collateral pool and that they even get locked out of deals,” Will said.
These concerns are all justified in a normal market, where soft sounding should not be necessary. Yet the practice is likely to stick around for a while because of the current market uncertainty and the setback it has caused in the covered bond space, said Will. “We haven’t had any issuance in a few weeks so it makes sense to start out slowly and do some sounding out.”
Shadow book building helps to minimise execution risk in the marketplace – something that is all the more valuable in troubled times, said Grossmann. As the market gets going again, there will be less need for soft sounding. “But now, we need it to get an idea of where the market is, because simply bringing a deal and then pulling it because it’s not at the right price causes a lot of volatility, and that’s not good for anyone,” he added.
