Strongly placed

The Scandinavian covered bond market is in rude health, with transactions comfortably oversubscribed, some even upsized, to take into account the continued wave of interest in the region. And with issuance volumes forecast to remain relatively unchanged over last year’s supply, foreign investors are champing at the bit, eager to buy up primary market bonds upon launch. Hardeep Dhillon reports.

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The Nordic region is expected to see strong domestic market issuance this year, with upwards of €25bn of euro-denominated transactions, of which roughly €15bn has already been placed with investors. UniCredit published its predictions for benchmark-sized transactions at the end of 2010. It projected Sweden will lead the fray with €12bn of issuance this year, up from €8.5bn in 2010. Norway is down for €10bn versus last year’s €8.9bn, while Finland will remain static at €5bn.

The covered bond product is generally witnessing greater interest due to pre-positioning for Basel III, where covered bonds have a more favourable treatment than senior unsecured bonds, said Heiko Langer, senior covered bonds analyst at BNP Paribas. “This will cement the structural bid for covered bonds because they are viewed as the only bank debt eligible for liquidity buffers,” he said.

International investors are increasingly keen on Scandinavian exposure. A good proportion of 2011 primary market supply is being placed with foreign investors, especially German portfolios. Bank treasuries in Germany have tended to buy shorter transactions in the three- up to five-year maturities, while insurance clients gravitate to longer tenors.

The German investor base has been increasing allocations to Scandinavian covered bonds on account of shrinking issuance volumes and dwindling net supply of German Pfandbriefe. “Redemptions of the Pfandbrief make it necessary for German investors to look abroad and to invest in other covered bond products,” said Ralf Grossmann, head of covered bond origination at SG. “The Nordics are a core covered bond market that is favoured strongly by the Germans.”

Roughly €70bn per annum of German product is taken out of the system, a fundamental trend that began in 2005 and will continue until 2015, according to Florian Hillenbrand, covered bonds analyst at UniCredit Markets & Investment Banking. “There is a natural shift of large German insurance companies, which traditionally heavily invested in German Pfandbriefe, towards first French and then the Nordic covered bonds,” he said.

Accounts in Germany and Austria were allocated 60% of Danske Bank’s €1bn five-year trade, in addition to over half of DnB Nor Boligkreditt’s €2bn five-year transaction and a similar level of Swedbank’s €1.5bn three-year deal. The latter deal also saw 18% of bonds place with UK investors. Stadshypotek’s €1.5bn five-year deal saw 38% of the bonds flow into German and Austrian accounts, with Asia taking 26% share of placement and the UK 14%.

SEB’s 2021 transaction, the first ever ten-year covered bond from a Swedish issuer, had a sizeable distribution to French clients, which bought up 23% of the bonds. Traditionally French investors prefer longer maturities and have been more reluctant to invest in five-year and shorter maturities from Nordic issuers, said Grossmann. “The high level of French participation was very encouraging and a sign that investors are comfortable investing long term in high quality credits and structures,” he said.

The US investor base has also taken a keen interest in Scandinavian covered bonds since Stadshypotek’s US$1.6bn two-year transaction opened the US dollar-denominated market for Scandinavian issuers in September 2010. Subsequent dollar deals followed from DnB Nor with a US$2bn five-year trade and SpareBank 1 Boligkrreditt with a US$1.5bn three-year issue. This year has seen Swedbank Mortgage AB, Nordea and DnB Nor each launch US$2bn trades in March, while SpareBank 1 issued a US$1.25bn five-year transaction in May.

The option of opportunistically tapping the US dollar-denominated covered bond market has changed the dynamic for Scandinavian issuers. It could alleviate supply pressure on the euro market, with little work needed to move a bond issue from Europe to the US, said Hillenbrand. “The Swedish or Norwegian kroner to US dollar market is as liquid as the swap market with euro,” he said. “If an opportunity arises where they could issue 10bp tighter in US dollars than euros, they could easily transfer to the US market.”

Choice of currencies

The dollar market will become increasingly important, providing stiff competition to the euro covered bond market, predicted Per Tunestam, treasurer of SBAB Bank. Though he admitted the relative attractiveness of various markets from a strictly cost benefit perspective does vary, having the option to raise funding in a range of currencies is very compelling for an issuer.

“It is all about diversification, for both issuers and investors,” said the treasurer. “It is about being able to access various markets from a fundamental standpoint, rather than trying to chase the last basis point from a technical cost saving perspective.”

Local domestic markets have served issuers’ needs well in the past and this has somewhat restricted international expansion of the Scandinavian covered bond product, said Ted Lord, head of European covered bonds at Barclays Capital. He expects the region to develop further into a multi-currency issuance market, as more issuers take a strategic decision to diversify sources of funding into other currencies, particularly US dollars.

“There is a greater awareness of the stability of Nordic covered bond markets and US investors are looking at investment alternatives and diversifying away from US agencies into covered bonds,” he said.

The US investor base has been receptive to high quality credits. Much of its traditional investment universe, such as government-sponsored entities and top-rated securitisation tranches, has fallen from favour. “There is tremendous interest from US investors in finding other solid Triple A asset classes to invest their money and covered bonds have been a resounding success,” said Hillenbrand.

Scandinavia has been buoyed by the stability of its domestic economies and its strong banking systems, with high quality assets and ample capitalisation positions, said Michael Symonds, credit analyst at Daiwa Capital Markets. Most Scandinavian banks have limited investments in international assets outside of their home markets, minimising their exposure to European peripherals.

“Their business models are generating revenue growth and credit provisions for loan losses are diminishing, in contrast to other European banks with greater peripheral exposure,” he said.

The Scandinavian region fared well during the financial crisis and was not forced to undertake wide scale bank rescue operations, said Heiko Langer, senior covered bonds analyst at BNP Paribas. The region has thus been spared the worst of the sovereign debt crisis that has ravaged much of Europe. Nordic investors have diversified away from the euro markets.

This has led to rising interest in Sweden, Norway and Denmark, where issuance was dominated by relatively stable banks. “Over the last two years, the Scandinavian market has played the safe haven card quite successfully,” Langer said.

Concerns about Scandinavian banks’ exposure to the Baltic States have also been abating in the last twelve months, as Baltic economies improve and sovereign ratings were upgraded. A number of the Scandinavian banks overshot their capital ratios following the Baltic crisis, particularly the Swedish banks. “SEB and Swedbank all recapitalised after their Baltic losses skyrocketed in 2008 and 2009,” said Daiwa’s Symonds. “The stabilisation in the Baltics has left these banks sitting with strong capital positions, according to pre-Basel III requirements for minimum capital standards.”

Scandinavian covered bonds have also been characterised by the high quality assets in the cover pools. The robustness of Nordic housing markets has been crucial. Residential markets did experience a downturn, but house prices have stabilised and recovered their losses since 2008.

Tunestam cites a report published by Riksbank, the Swedish central bank, into risks associated with the Swedish housing market. It found no evidence of a housing bubble. “Scandinavian covered bonds will continue to be sought after by international investors as there is no cause for a major setback in the residential housing market from a fundamental perspective,” Tunestam said. “Sweden has a very buoyant and strong housing market, demand is much higher than supply due to low construction.”

Investor discussions have highlighted concerns about the relatively high house prices, especially in Sweden and Norway. Though Sweden has taken steps to ease house price inflation, Langer believes a slight correction could be healthy for the market, though a significant drop in house prices could create headline risk.

“A large part of the price dynamic of Scandinavian covered bonds is based on being a safe haven A slump in house prices could be felt in the performance potential of the covered bonds,” he said. However, “sound fundamentals and relatively low unemployment are seen as a mitigant to the bursting of any housing bubbles.”

Meanwhile, spreads on Scandinavian covered bonds have remained stable, exhibiting very low volatility compared to some other European markets. Spreads have outperformed France and some deals are trading significantly through French covered bonds. This is explained to a large extent by increasing covered bond supply from the French market, roughly €51bn of new material in 2010 alone, resulting in a weakening of French spreads, said UniCredit’s Hillenbrand.

Scandinavian spreads have closed the gap to Pfandbriefe, but a further narrowing is more likely to come from a widening of the German curve than a significant tightening from the Swedish or Norwegian markets, predicted Langer.

“Reception for Nordic deals is very good and we are still seeing high levels of oversubscription. However, in the current environment, some investors are looking into segments that offer more spread, such as the UK, Dutch or French markets,” added Grossman.

DNB Nor opened the market in January with a €2bn deal priced at mid-swaps plus 32bp, demonstrating the tighter pricing levels of primary market issuance. However Stadshypotek set the bar lower for the tightest priced five-year transaction from a Scandinavian issuer with its record 31bp. SEB priced its €1.25bn deal at 58bp over mid-swaps – just 1bp wider than a ten-year trade from Germany’s Eurohypo.

Finally, the covered bond markets offer a good alternatives to the region’s sovereigns, which have lower supply volumes and less attractive yields, said Lord. “Covered bonds offer a good yield pick up relative to the government bonds of Norway or Sweden. In the case of the Kingdom of Norway, new issuance is practically non-existent. You could argue yields are not the same as some peripheral countries, but the Nordic region does not have the same risks associated with it compared to many other European economies.”