Covered bonds: Storm clouds gather over covered bonds


Jethro Wookey
Published on:

With a huge pipeline of covered bond issuance planned for the next few months, much is being asked of investors. There might not be enough of them to go around.

The summer break is over and the covered bond market is preparing to receive the glut of issuance that traditionally follows it. But the situation this year is markedly different to previous years, as issuers attempt to account for a shortfall of some 30% in covered bond issuance this year over the same point in 2007. Accordingly, the weight of supply following the summer break is being felt earlier than in previous years. "This year, supply pressure started in mid-August," says Timo Boehm, portfolio manager at Allianz Global Investors. "It seems to us that some issuers are trying to be first to market, which might be the best strategy for them in this environment."

Timo Boehm, Allianz Global Investors

"It seems to us that some issuers are trying to be first to market, which might be the best strategy for them in this environment"
Timo Boehm, Allianz Global Investors

There are concerns that the covered bond investor base is ill equipped to take on the €20 billion of issuance that, according to Société Générale, is expected to materialize over the coming months. Only in the most liquid of credit environments could that be achieved, as there simply isn’t enough fresh money to absorb such levels without a functioning secondary trading market, which has been the main victim in the covered bond sector of the credit crunch. Many investors will be reluctant to commit funds in such an illiquid environment until proper pricing levels have been re-established. Eurohypo’s €1 billion, five-year mortgage Pfandbrief in late August was seen as a success by the market in general, and certainly it was an attractive deal from an established name with a good reputation. However, according to one covered bond head, more was expected of the deal. Despite the quality of the issuer, the book only reached about €1.25 billion, with some 75% of the deal going to domestic German investors. Without that strong domestic investor base, which only Germany and, to some extent, Scandinavia are presently able to offer, many deals are going to struggle for takers. The liquidity crunch has had the well-publicized effect of turning a seller’s market into a buyer’s one, and investors are no longer willing to buy just any covered bond. They can pick and choose, and the issuers are facing a much harder proposition than before last summer’s crisis.

New names join the crowd

It is not just the credit crunch that has given this power to investors. Since well before last summer, there has been a steady influx of new names into the covered bond market, which would have caused difficulties even if the crunch had not happened. Many planned deals in the congested pipeline are either from debut issuers, such as Italy’s UBI Banca, or from recent entrants to the market, such as Norway’s Sparebank 1. A large proportion of covered bond investors will not have such names on their lists, meaning that from a research perspective these issues will require a lot more hard work than those from more established names. "Every year, we see a lot of new issuers but the capacity at the fund managers, banks and other investors has not changed," explains Lars Dalitz, portfolio manager at the European Central Bank. "One institution cannot track 80 or 90 different names properly. Even before the crunch, we as investors had to decide how to contain the number of issuers we look at."

The problems that are related to the credit crunch have therefore compounded the process of investors becoming more selective about which issuers they look at. The main concern is the revelation of the extent of the credit component in deals. "In covered bonds, we were quasi-government investors," says Lucette Yvernault, portfolio manager at Schroders. "That changed a lot with the recent developments in the asset class. We now look at covered bonds as a top-quality credit product."

Covered bonds go short

Mounting supply pressure at short end of curve

Source: Dresdner Kleinwort Research

Not all investors were so adaptable, and many simply ceased investing in covered bonds, depleting the investor base and making opportunities for successful issuance still harder to find. All told, the environment into which the dauntingly large pipeline of covered bond deals is headed is a precarious one.

Unattractive UK

Since the summer, deals from Germany and Sweden have successfully pierced the market, with Münchener Hypothekenbank and Bayerische Landesbank for the former and Swedbank and SEB representing the latter. But these are the two markets that enjoy the benefit of a strong domestic investor base. It is very doubtful that issuers in other markets will be able to get deals away as easily, especially in markets that have been closed to investors for some time, such as the UK. The UK covered bond market has for several months been confined to retained issues that are fed into the Bank of England’s special liquidity scheme. Recently, Abbey retained £13 billion ($23.4 billion) in covered bonds in a week for inclusion in the SLS. The Bank of England has said that there are no plans to extend the scheme beyond October, so covered bond issuers will have to return to the public markets, where it is unlikely that they will receive a particularly warm welcome. Not only are investors somewhat piqued by what many see as an overuse and even abuse of the SLS – meaning that transactions are kept away from the public markets and therefore from the minds of investors – but many feel that the UK’s covered bond framework is still too flexible, and therefore unfavourable to investors looking for clarity. "The UK has a law-based framework now but investors don’t like it," says one. "It is not very detailed, and there is still a lot of leeway for different programmes. Much more effort is needed."

This demanding attitude is now a common feature among investors across the covered bond spectrum. With so many deals coming to the market over the next few months, issuers will have their work cut out to achieve success. And the stakes are high. Investors have become used to the kind of spreads that would have seemed impossible before the disappearance of the market’s liquidity, and issuers are becoming resigned to offering them. But these levels are not sustainable in the long term; at some point they must be brought back. "If you can’t restore liquidity, the market won’t be the same as before," says Dalitz at the ECB. "There has to be sufficient liquidity to restore a functioning market, and there is not now. If it stays like this, it will be a big problem for the market."

Mounting pressure

Dalitz admits to being concerned that the difficult environment will be prevalent for longer than most people are expecting. While many predict that the troubles should begin to be alleviated some time next year, that might be more a case of hope than expectation. With the yield curve for covered bonds so flat because of uncertainty in the market, most investors have been focused on maturities of two or three years, and most issues of the past several months have come in this bracket.

That means that if the illiquidity in the covered bond market does continue for more than another year, things could very quickly become even worse. "If most issuers come in the two- to three-year maturity bracket, we will see a lot of supply in 2010 and 2011 through redemptions," says Boehm at Allianz. "If the crisis is not over by then, there will be a lot of pressure."