Covered bonds and structured covered bonds: Rocked to its core?

ALL COVERED BONDS are equal. But some are more equal than others. That message came through loud and clear not just from the suggestion at the height of this summer’s liquidity crisis that the market be subdivided into core and non-core sectors. That ill-advised and hastily withdrawn proposal, aired by ACI Germany, was shouted down amid a crescendo of opposition from existing or potential issuers that took exception to being branded as second-class citizens in the covered bond world. It was also plain enough from the performance of the covered bond market at a secondary and primary market level. "It is very obvious from the performance of spreads that there has been a considerable increase in differentiation in the covered bond universe," says Ted Packmohr, senior covered bond analyst at Dresdner Kleinwort in Frankfurt. "The clear winners, spread-wise, have been the German Pfandbriefe and the French obligations foncières, while the issuers that have suffered have been the US, UK and Spanish names."

A tiering process that had been visible in the secondary market in August, most notably in the case of Northern Rock, became equally conspicuous when the primary market hesitantly reopened in early September, giving a distinctly lukewarm welcome to UK issuers. In the case of Nationwide’s €1 billion five-year transaction, the revision of price guidance from between 11 and 12 basis points over swaps to 15bp is described by one banker as "almost a scandal in the covered bond world".

In vivid contrast, by the end of September, borrowers such as LBBW and Norway’s Sparebank were demonstrating that for some borrowers prepared not to push the pricing envelope too far, primary market demand was back with an emphatic bang. LBBW’s €2 billion five-year benchmark generated total demand of well over €5 billion at its originally indicated level of flat to swaps, allowing for pricing to be revised to 1bp through mid-swaps. The same week, Sparebank’s debut €1.5 billion three-year transaction was viewed by some bankers as an even more important landmark for the rehabilitation of the covered bond market – chiefly because, as a new name from a relatively new jurisdiction, it did not drain liquidity from existing issues.

Perhaps more telling than the difference in performance of covered bonds from market to market, however, has been the variance in the spread performance of law-based and structured covered bonds from the same jurisdiction. More specifically, at the height of the crisis there was a pronounced difference in the performance of obligations foncières based on French law and those structured bonds issued by banks such as BNP Paribas and Crédit Mutuel.

As research published by Barclays Capital points out, while in mid-June the average spread between the two covered bond types stood at a very modest 1.5bp, by mid-September it had reached a maximum of about 18bp, before narrowing again to 12bp a month later. Given the sharp underperformance of UK structured covered bonds over the same period, the oversimplified conclusion to draw from this divergence in performance is that it was structured covered bonds that were responsible for besmirching the good name of the asset class. Superficially, that conclusion would appear to vindicate those who were warning against the perils of structured covered bonds before this summer. Bodies such as the association of Pfandbrief banks (VDP), for example, have made little secret of their opposition to the use of the term covered bond to describe structured instruments. The oversimplified conclusion would also seem to vindicate investors such as those German insurance companies that have publicly announced that in markets with perfectly efficient covered bond laws they will not consider buying structured instruments.

A handful of German insurance companies, perhaps too steeped in the culture of the Pfandbrief market for their own good, are unlikely to be deal-breakers as far as the market for structured covered bonds is concerned. Besides, the argument that structured bonds are collectively the enfants terribles of the covered bond world fails to stack up persuasively for a number of other reasons.

One of those has been the continuing primary market demand for structured issuance in spite of spread widening earlier in the year. According to Derry Hubbard, head of covered bond marketing and execution at BNP Paribas, when the bank launched its most recent short-dated two-year €2 billion structured deal in October, at mid-swaps plus 4bp, it attracted more than 100 individual accounts, many of which were new to the BNP Paribas programme. Although the pricing might have been much more generous than the issuer would have hoped for before this summer’s crisis, that is not a bad reception for a structure that some have suggested deserves pariah status. "We recognize that we may still have some work to do in terms of marketing our bonds," says Hubbard. "But we believe we have developed a massive investor base that continues to grow."

That view is supported by others in the market. "Some may argue that structured covered bonds are inherently more risky than law-based products but I know a number of clients who prefer structured products," says Armin Peter, head of covered bond syndicate at UBS in London. That preference, he explains, springs from the additional enhancements and sometimes more detailed post-insolvency contractual provisions backing structured bonds in such markets as France, the US and the UK.

"We recognize that we may still have some work to do in terms of marketing our structured bonds. But we believe we have developed a massive investor base that continues to grow" Derry Hubbard, BNP Paribas