Since the financial crisis in late 2008, covered bonds have moved into the spotlight as relatively low-cost instruments that European banks can use to refinance themselves.
“Covered bonds are a fundamental source of funding and they are now more important than they ever were,” says Max Sinclair, head of UK lending at Eurohypo. These instruments have existed for over 230 years and today they are one of the largest sectors of Europe’s bond market. Basically, covered bonds are securities backed by the cash flows from high-quality mortgages and public-sector loans.
But unlike commercial- and residential-backed mortgage securities, the loans stay on the bond issuer’s balance sheet, are ring-fenced in case of insolvency, and in 25 European countries are governed by special legislative frameworks that control their quality and other key issues. When the credit crunch hit in October 2008, the covered bond market, like others, froze. But by early 2009, it reopened, with banks like Eurohypo issuing covered bonds, although the spreads they offered investors had rocketed to over 100 basis points.
These were banks’ only wholesale source of funding – apart from government subsidised ones, such as government-guaranteed bank bonds. “But at the start of the crisis, issuers relying on government guaranteed bonds exposed themselves to a certain stigma, indicating to the market that at that point they had only limited capital market excess,” notes Leef Dierks, a covered bonds analyst at Barclays Capital.
As the credit crunch continued, that stigma faded and government-guaranteed debt started to crowd out covered bonds. But in May 2009, the instrument received an unexpected boost, when the European Central Bank announced it would buy €60bn of covered bonds “to help revive this market in terms of, liquidity, issuance and spreads”.
Increase in supply
“We have seen supply coming from Spain, Germany and France, among others, and, attributed to ongoing ECB purchases, spreads have contracted markedly; in Germany, for example, they have fallen back to pre-crisis levels,” says Dierks.
Harin Thaker, European CEO of Deutsche Pfandbriefbank, adds: “Given improvement in liquidity from this source, more lenders have returned to lending in France, Germany and the UK. They are sharing the benefit of covered bond funding with their clients.”
During the credit crisis, margins on real estate lending had shot up to more than 200 basis points, but now, with funding costs lower and more banks competing to lend, they are dropping.
Because covered bonds provide a way of recycling the capital locked in mortgage loans, they are especially useful for banks and institutions that are either specialist real estate lenders or large-volume residential mortgage providers. For example, just over half of Eurohypo’s €340bn funding in mid 2009 was via covered bonds.
There is also an important additional benefit: under Basel II requirements covering bank reserves, covered bonds are considered liquid instruments. Once loans are bundled into these packages, banks need to hold less regulatory capital against them than they would be required to hold against the loans themselves.
Moreover, funding via covered bonds is also cheap: banks can now issue the bonds at a spread of between 10 and 55 basis points over the midpoint of Euribor or Libor swap rates. Unsecured corporate or interbank borrowing is more expensive.
Issuer strength affects pricing “If you look at pricing and the success of different issues, it mostly depends on the strength of the issuer,” says Tobias Ilgen, head of treasury at WestImmo. “Otherwise you couldn’t explain the difference in spreads between, say, German pfandbrief and Spanish cédulas.
“Or within one country, there is different pricing for different issuers. Very good, strong banks with good distribution channels can sell bonds for sub-Libor rates in the shorter maturities. On the other hand, you have problematic banks where the issuer is weak, and they have to pay 30-40 basis points over swaps. But depending on maturity, spreads for German covered bonds are between 10 and 25bps.”
The major rating agencies are also increasingly focusing on the issuers in their assessments of bonds. “They argue that the full and timely repayment depends on the willingness and ability of the issuer to do so,” says Dierks.
Jumbo, or benchmark-covered bonds, are listed, euro-denominated, fixed-rate issues of €1bn minimum. Introduced in 1995, they are the most liquid because there are market makers to quote two-way prices; jumbos account for nearly 60% of Europe’s €238bn of outstanding issuance.
There are also other, smaller issues that can be either publicly or privately placed. Privately placed bonds – termed registered in Germany – can be structured to suit an investor’s requirement.
“Registered covered bonds are doing extremely well today,” notes Dierks. “They are highly attractive to German insurance companies, for example, because according to German accounting rules, they do not have to mark them to market, but can hold them at book value.”
Ilgen says: “Long term ‘real-money” investors – insurance companies and pension funds – are not interested in mark-to-market volatility, but in stable investments. So most of them prefer this kind of covered bond. You can tailor them. They are easier and cheaper to issue – a small issue of €5m is not a problem.”
Investment funds, banks, pension funds, insurance companies and central banks are the main buyers of covered bonds. From the investors’ viewpoint, the quality and security of covered bonds are a big attraction. They are less risky than plain vanilla, unsecured bank debt.
Since the loans backing covered bonds stay on the banks’ balance sheets, the credit risk also stays with the bank; investors have full recourse to the issuer if the bonds go sour. However, to date, no covered bond has yet defaulted.
The ECB’s buying programme is due to be wound down in June and most are expecting a smooth exit. “We are forecasting a widening in spreads of 10, perhaps 20 basis points,” says Dierks. “This is fairly modest if you bear in mind that less than a year ago, some pfandbrief traded at hundreds of basis points over mid-swaps.” Ilgen concludes: “I believe covered bonds will be the best and cheapest way to achieve funding, especially for the long-term. The focus is more and more on matching assets and liabilities. Real estate loans are normally long term and banks are seeking long-term funding, so covered bonds will be the best match.”
Pfandbrief have the edge for German bankers
One German banker who lends in the UK explains the appeal of covered bonds for banks thus: “We know the cost of refinancing the covered-bond value of the loan and we know the cost of financing the top slice in the interbank market, so we know how much we need to charge to achieve any given return on equity for the bank. “Even before we make a loan, we know how much of it is eligible for pfandbrief cover.
For pfandbrief, you can put in 60% of the loan to value. However, the value of the property is based on the ‘sustainable’, or German ‘mortgage value’. As a rough guide, before the crash, we could put in 48% of the loan, because the German mortgage value of the property was then about 80% of UK open-market value. “Now, because open-market values have dropped so much in the UK, around 95% of the UK market value we fund is eligible for the pfandbrief pool.”