Pfandbriefe fail to outshine rivals despite quality

In a period of uncertainty, Pfandbriefe ought to flourish. Yet the German mortgage bond market is still slow, hit by adverse swap market conditions and credit concerns springing from radical restructuring among the German banks. Even so, rival breeds of covered bonds in France and Spain are doing well. And Ireland aims to create a superior legal framework to put Germany in the shade. Could this rivalry give covered bonds a much-needed shot in the arm?

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David Brickman

All year, German mortgage bankers have been assuring us that quality will always tell in the end. This in the face of new issues having been virtually non-existent for most of this year, and analysts consistently bearish on the asset class. But, the bankers insisted, next time the financial world was rocked by a disastrous, confidence-sapping event, the Pfandbriefe would suddenly come back into fashion because of their safety. Investors, it was argued, would flock to covered bonds, attracted by their long default-free record and yield pick-up over governments.
It's hard to think of an event better suited to trigger this quest for safety than the recent outrages in the US. Markets around the globe scrambled into what one head of high-grade credit research called "a classic textbook example of a flight to quality". But there has been no sign that large volumes of money have moved into covered bonds. Instead, agency borrowers such as Freddie Mac, the EBRD and KfW have stolen most of the limelight, and Pfandbrief issuers risk being left behind.
This year has been a dismal one for Pfandbriefe and the covered bond market generally. After record new-issue volume in 1999 and 2000, there was a strong start this year, with e26.6 billion ($24.1 billion) in the first two months. But volumes steadily dropped off, almost shutting down for the summer. The primary market recovered briefly following the attacks in the US; in the second week of October, e5 billion was issued in jumbos - e3 billion in obligations foncières issues from Dexma and new issuer CIF Euromortgage, and e2 billion from the German state of Hessen. Alongside this, banks tapped four issues for a total of e1.6 billion. Between 18 and 26 October, there were 10 tap issues - against a total of only 92 issues this year. Bankers speculated that this could be the start of the long-awaited recovery of the market. But the rally was short-lived.
David Brickman, European high-grade strategist at BNP Paribas, says: "In the aftermath of September 11, Pfandbriefe benefited from significant demand, as investors switched out of corporates and into agencies and covered bonds, though there was also an understandable further flight into sovereigns and cash. Several issuers made opportunistic taps to take advantage of this demand and the spread tightening versus Bunds it caused. But over the last week [commencing October 8], levels have stabilized and then widened out again."

Brickman continues: "Mortgage banks still seem unwilling or unable to come to the new-issue market in large sizes - i.e. e1billion or more. New funding levels are still unattractive. We're seeing around the lowest level in 10-year swap spreads since the days of Emu - they are now at about 30 basis points. Very tight swap spreads have pushed many Pfandbrief Libor spreads into double-digit territory."
Much of this lack of issuance and spread widening in the secondary market can be attributed to factors beyond issuers' control, particularly the performance of the swap market. Norbert Meisner, Pfandbrief analyst at Deutsche Bank, says: "In absolute terms, versus Bunds, Pfandbriefe continue to perform. Narrowing Bund-swap spreads have caused Bund-jumbo spreads to come in. But as these have narrowed, there has been profit-taking at the long end, so that Pfandbriefe have continued to cheapen versus swaps. The primary market remains very difficult, especially at the long end. There is not much demand."
Ralf Grossman, senior Pfandbrief analyst at CDC Ixis, agrees. "Pfandbriefe have been performing quite well relative to governments," he says. "If you look at them versus swaps they are still disappointing, but this is a general market trend and we should look at them against governments. Jumbos are at the high-quality end of the credit range, and many investors have been switching into them because of their low risk and relatively good yield. Performance versus swaps has been affected by the strength of the swap market related to the steep yield curve, but versus governments spreads have narrowed or stabilized. Medium-term paper in particular has done quite well - the curve has steepened, and supply at the long end has dried out over the last month."
Banking upheaval
But there's another far less technical and much more worrying reason for the persistent weakness of Europe's biggest bond market. The German mortgage banking sector is going through a period of radical transformation, and many of its weaker players are expected to consolidate or fail before things stabilize again. Margins are falling, and there is less business to go around. Meisner adds: "There are also more specific factors, such as the merger between Deutsche Hyp Frankfurt, Eurohypo and Rheinhyp, which seems to be going ahead. Many investors have been selling these names to avoid being too exposed to a single institution. And there are industry-wide problems, such as the credit concerns around specific names." But Meisner prefers to emphasize the technical factors. "I would say that the impact of these [credit concerns] accounts for only perhaps 15% of the market's difficulties - the other 85% is due to technical problems such as curve steepening and swap spreads." The bad news is that there's no prospect of these factors reversing soon. "We are not looking for a quick turnaround - we would need a substantial widening of Bund-swap spreads to see much new buying interest."







View graph.

Brickman at BNP Paribas puts somewhat more emphasis on the German banking industry's internal problems. He says: "There are question marks over certain Pfandbrief credits. Some are already restructuring, such as Deutsche Hyp, Rheinhyp and Eurohypo, which are in three-way merger talks. There's a general perception, which I don't think is going to go away soon, that the Pfandbrief market is in a state of flux, with credit concerns and rating instability. You don't see that instability in the obligations foncières or cédulas hipotecarias markets."
On October 15, Essen Hyp had its ratings cut by Fitch to A+ from AA-. This is just the latest in a series of downgrades, real and threatened, that have dampened confidence across the market. AHB, which has now merged with Rheinboden to form AHBR, saw its spreads widen on rumours of downgrade, though so far these have proved false. DePfa and HypoVereinsbank are restructuring to stay competitive in tougher markets. The BG Berlin group had its ratings cut by Moody's in July, and its issuing subsidiary LB Berlin's Pfandbrief ratings remain on review for possible downgrade.
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