Uncovering covered bonds

The covered bond market is undergoing a period of transition: issues such as a supply shortage, disclosure, regulatory shortcomings and developing markets are all affecting the market. A number of covered bond practitioners give their opinions on these issues

How have the problems experienced by agency issuers such as Freddie Mac affected the covered bond market?

The Freddie Mac problems have not really influenced the European covered bond market with respect to pricing and spreads. But investors have realised that even with a triple-A rating there is some credit risk left and that one should have a closer look at how the coverage is provided. Therefore investors are now analysing more thoroughly the legal framework, the support mechanism and they require more details about pool performance and business models.

Does the UK need true legislation for its covered markets?

The problem with he UK quasi-covered bond programs is definitely the missing legislation. Due to this lack, they carry a higher risk weighting and some investors, for instance the German asset managers, do not regard them as ‘Pfandbrief’ as they are not included in the approved list that is compliant with the European Directive on Undertakings for Collective Investments in Transferable Securities (UCITS). Therefore they have to regard them as corporate bonds with a very high rating. This classification hinders some investors to invest in these issues. Beside the legal concerns, all programs vary slightly with regard to the documentation and structure, which require additional efforts for analysing the transaction. Thirdly, later issues may be issued with a different documentation than the previous ones. This will split the market and does not help liquidity.

With low supply from the German market, do you think that the covered bonds market is currently suffering from a liquidity crisis?

Liquidity is definitely missing in the longer end of the covered bond market, so maturities around 10 years and longer. Some new issuers have entered the market with good success. But these new issuers, especially the Spanish issuers, are only building up their maturity curve slowly. Therefmore diversity in some maturities is missing. Another gap is current coupons and issues trading below par, which explains why these issues trade very expensive. Some very specific requirements of end investors cannot therefore be met. So in some segments more different issuers would be favourable, but overall I cannot see any liquidity crisis.

How will the structured credit market, where investors are able to gain exposure to any rating, affect the triple-A status of covered bonds? Are triple-A ratings for covered bonds even required?

The residential mortgage-backed securities and the covered bond markets will grow together and with more legislation to come (from UK and Italy), some major issuers will use the covered bond markets more frequently. The covered bond market will and should fill the niche between government paper and structured paper with triple-A paper providing good liquidity and a higher interest return. The structured market will then pay the investors for the credit analysis, lower standardisation of documentation and monitoring and will hopefully provide more exposure to lower-rated tranches.

How transparent is the market? Is more disclosure required?

The information provided has already improved. But investors will require more regular updates on mortgage pool developments and business strategies. The trust in external ratings has diminished and also covered bonds with a triple-A rating are viewed as credit products and not just as a substitute for government paper. Issuers are required to further improve their information policy (e.g. quarterly updates, data supply through the internet, regular investor meetings) and provide performance data on the mortgage pools in a standardised format.

Why are covered bonds so attractive to issuers?

Covered bonds allow issuers to obtain large volumes of cheap long-dated funds. At the long end of the curve spread differential between senior debt and covered bonds is relatively larger than that in the shorter term. Thus most issuers use their senior debt programmes for funding in the short end of the curve (up to 5 years) and covered bond issuance for longer dated debt.
Another important factor in the covered bond market is its high liquidity. This in general suggests that most issues will be actively traded giving investors the opportunity to buy and sell whenever necessary. Thus no issue should quote an “out-of-the-market” spread.

How will the introduction of new markets such as Italy, Norway, Sweden and Finland affect the market?

Newcomers are always welcomed to the market since they help to consolidate it. Past experience has proved that whenever a new country has joined the market this has brought more depth into the market. Prior to HBOS’ first issue hardly any covered bonds were sold into UK accounts, after HBOS’ inaugural issue, many UK investors have looked at the market with different eyes. When investors from other countries begin to be more familiar with the covered bond structure they will look for other issuers abroad with the same or better asset quality.

With low supply from the German market, do you think that the covered bonds market is currently suffering from a liquidity crisis?

Germany has been the main provider of the covered bond markets in the past. However, low supply from Germany has been accompanied by higher supply from other countries. In the case of Spain, the cédulas hipotecarias market has grown to be one of the most important debt markets in Europe. The total size of the market is €76.8 billion, of which €31.05 billion was issued in 2003. Already €16.5 billion has been issued in the first four months of 2004 and the total expected amount to be issued in 2004 is approximately €45 billion. Average size of the issues is close to €1.8 billion, which makes it one of the most liquid markets in the world. So far this year, the cédulas hipotecarias market is the second largest within the covered bond sector, following the German Pfandbriefe market. The cédulas market is the market leader if only jumbo issues are taken into account. Furthermore, prospects for future issuance remain very positive. Even if no new mortgages were given out in the Spanish market, the size of the existing underlying market already would enable Spanish banks to issue a further €150 billion of new cédulas bonds, which is twice as much as the current outstanding level. However, since the evolution of the mortgage market in Spain is still very strong, with expected year-to-year growth of double-digit figures for at least the next five to ten years (23% rise in 2003 figures), Caja Madrid predicts that the cédulas market will remain as one of the main bond markets in Europe in terms of liquidity in the next few years.

Is EuroCredit MTS’s attempts to broaden its platform, by lowering the criteria for eligibility, good for liquidity and trading?

EuroCredit MTS announced on April 21 the expansion of its listing criteria to include euro-denominated covered bonds of at least €2 billion in size from benchmark issuers. The move comes in response to a change in market conditions, which has resulted in an evolution of covered bond benchmark definitions. While smaller in size, today’s covered bonds behave just like the larger benchmarks: the issues are priced and quoted by a majority of dealers and are subject to exactly the same market making commitments as those issues above the €3 billion mark.

While the minimum issue size shifts down to €2 billion, the main eligibility and listing criteria for EuroCredit MTS will be maintained. As with larger benchmarks, covered bonds of €2 billion must secure the commitment of at least seven market markers, must be issued in the last 12 months and are required to have a minimum rating of triple-A by one of the rating agencies. In addition, to be considered a benchmark, the bond’s issuer must have at least €10 billion in total outstanding debt, or €8 billion with the commitment to reach €10 billion within 12 months from first listing. The issuer must also have at least one eligible security outstanding and plans to issue at least one new eligible security in each 12 month period subsequent to the first listing on EuroCredit MTS. Seven new issues of cédulas have been included in MTS after this change and for the cédulas sector it is a way to reassure our commitment with liquidity.

Would a shift to rating all covered bonds as triple-A as a standard rather than a structured basis hinder or help investors?

It can be both, but we think it would be helpful for investors because it would lead to a change in investor approach for some issuers that now are more opportunistic. If all issuers were rated triple-A, differentiation among them should come from a more investor friendly approach including frequent roadshows to update the strategy of the issuer, future funding plans, use of clear execution procedures (pot vs retention) and taking into account investor preferences for any new issue. Caja Madrid and TDA (Titulización de Activos) are already committed to this strategy because we are firm believers that the pot system brings transparency to the market, thus enabling all market participants to feel more comfortable with the issue at hand. We believe that through the pot system investors obtain the bonds at the level they want, the lead managers get remunerated for the job that are doing, and the issuer pays a fair price for its deal.

What are the plans to cooperate on standardising different jurisdictions’ regulations and products?

The German Mortgage Bank Act of 1900 provided the original regulatory framework for the covered bond market. Over time, this framework has been adopted and enhanced by the new countries issuing covered bonds, most notably Ireland. The Central Bank there imposed a minimum degree of over-collateralisation to increase investor protection and this has been included in the recent amendments to the German Mortgage Bank Act. In July 2004, Sweden will adopt the same format as that of Germany, France and Ireland. While no specific regulations govern the UK at present we believe that, in order to participate in the demand for this product, it will eventually adopt the regulatory format being used by the rest of Europe.

Does the UK need true legislation for its covered markets?

Covered bonds are popular for the added yield they offer over government debt coupled with similar risks and good liquidity. However, while most jurisdictions have a risk weighting of 10%, covered bonds in the UK have been given a 20% risk weighting. This increased risk may restrict certain investors from entering the UK covered bond market, thus reducing demand. Currently UK deals are structured with credit enhancements to alleviate the lack of regulation but these structures seem very similar to the more illiquid residential mortgage-backed securities (RMBS) market and have not thus fully allayed investor reluctance to invest.

Is it a weaker market for not having any legislation?

We believe that the credit enhancements enshrined in each of the issued bond structures are sufficient to counter the lack of regulation. In addition UK bonds tend to have an added risk premium over the regulated markets. However a strong regulatory environment has been the cornerstone of the covered bonds market, which has produced no defaults in its 230-year history. Thus, in our view, unless the UK adopts similar legislature to its European counterparts, investors will continue to associate the UK covered bond market with the traditional RMBS market. As a result investor appetite for UK covered bonds will fall, weakening the market as a whole.

With a low supply from the German market, do you think that the covered bond market is currently suffering from a liquidity crisis?

While it is true that supply has fallen in the German Pfandbriefe product since 1999, it has been more than offset by the growth in the other European markets. The Spanish market alone has been growing exponentially over the past four years and now stands at around €75 billion or 13% of the overall market. Meanwhile, the Irish market has increased by €10 billion in 2003 and is expected to double in size in 2004. In addition to the new supply, almost all issuers now come to the market in benchmark size as international investors are guaranteed liquidity when bonds trade on the Euro MTS platform. Thus we remain comfortable with market liquidity and, indeed, see this as improving.

Is the optimism that banks see in the covered bond market justified?

Probably not, but cyclical factors could see the asset class become less favoured. Until now, investors’ appetite for covered bonds has been twofold. Firstly, the low interest rate environment has driven investors in search of yield pickup to enhance returns and, secondly, these returns were offered at very little extra risk. In contrast the credit markets appear to be overvalued at current levels given their greater level of risk.
However, we do feel that, as interest rates start to rise and if equity markets return to an upward path, demand for this high quality asset class may wane as investors seek higher returns from other products. In addition, the rally in real estate prices has given investors a level of comfort about the high quality of assets backing these bonds. A severe consolidation in property prices could potentially have a profound effect on the covered bond market.

Does the UK need true legislation for its covered bond market?

The European covered bond market has seen issuance to date of €11 billion from three different issuers since HBOS’ inaugural transaction in Summer 2003. The broad primary distribution of new issues and the high level of secondary trading activity is evidence of the acceptance of the product by major covered bond investors.
UK Common Law provides the legal framework for UK covered bonds and contains all important features of existing Covered Bond structures. Given the acceptability to investors of a number of structural variations since the first HBOS deal it is debatable whether specific UK covered bond legislation is necessary.
Issues such as risk-weighting and UCITS eligibility still need to be resolved but are not regarded as major obstacles by the vast majority of investors.

Is it a weaker market for not having any legislation?

We don’t think so. The rating agencies have already extensively commented on the robustness of the outstanding covered bond structures and awarded their strongest ratings. The strong de-linkage of the bond rating from the issuer rating significantly exceeds other existing covered bond markets such as in Spain and Germany.
Whilst we might concede that technical and regulatory constraints may limit the prospective investor base to a slightly smaller subset of the overall covered bond investor base, the large amount of liquidity invested in the European Covered bond markets more than compensates for these factors.

Will UK building societies use the Irish ACS Market to lower their funding costs?

UK building societies are looking at the covered bond markets in general as a tool to diversify funding, enlarge their investor base and to optimise overall funding costs. However, as most of the mortgages originated by UK building societies are on UK balance sheets, a transfer of those assets into jurisdictions outside the UK can be complex and has significant tax and legal implications.
An alternative for UK building societies may be the creation of a pooled covered bond that is supported by a number of issuers. This should enable them to overcome the high market entry barriers as far as required minimum volume and structuring costs are concerned.

Is the optimism that banks see in the covered bond market justified?

There is no reason not to be optimistic about the covered bond market. The market has developed from a pure domestic German market into a European market with a global investor base in a relatively short time. The covered bond market is the largest single bond market in Europe and is therefore on the radar screen of every investor.
Further European expansion and changes in the regulatory environment with Basel II gives rise to the expectation that the covered bond market will gain importance and global recognition.

Is Euro Credit MTS attempts to broaden its platform, by lowering criteria for eligibility good for liquidity and trading?

Original EuroCreditMTS rules originate from a period of very wide swap-spreads and extremely large issue sizes of up to €5 billion in 2000. The market has clearly changed and liquidity is not defined by issue size only anymore. The lowering of eligibility criteria needs to be seen as a prudent reaction to a change in market conditions. This development is also reflected in the supra- and agency market.
In general the covered bond market can be seen as the second most liquid bond market, just behind the sovereign markets. Even during times of great uncertainty, cash- and repo markets have been robust and provided investors with unparalleled liquidity.

Why are covered bonds so attractive to issuers?

Issuers can kill two birds with one stone with covered bonds. They can reduce their borrowing costs and achieve a much wider investor base at the same time. These covered bond investors often then purchase senior unsecured debt from the issuer as they become more comfortable with the credit.

What do covered bonds offer investors other than just an alternative to the highest-quality government or agency debt?

The spreads on covered bonds offer an increased yield with often similar credit quality and an acceptable liquidity. In addition, the investor purchases a debt instrument from issuers who are tightly controlled in what they can and cannot do. Governments need often to be self-disciplined in their borrowing activities. Interestingly, we are seeing more and more North American investors moving into covered bonds because no one covered bond issuer dominates the market like you see in the US agency market. They also like the spread of risk that you get when investing in covered bonds.

Does the UK need true legislation for its covered markets?

So far, this has not proven to be the case. We have seen heavily oversubscribed deals as investors find the financial condition of the issuers and the UK diversification appealing. The investor protection under the UK structures is very robust. Looking ahead, however, the pressure to have a formal legislation will grow as the market expands. It is one thing for an investor to have a UK covered bond exposure of €100 million without a formal legislative framework. It is another thing for the same investor to have a UK covered bond exposure of €1 billion without a formal legislative framework.

Is the optimism that banks see in the covered bond market justified?

I think so, as long as the banks take a medium-term view. In a volatile world, investors are increasingly turning to covered bonds for the yield, investor protection, and the liquidity that they offer. In each benchmark where we are involved, there is always a significant number of first-time investors. In addition, the market is now beginning to spread beyond Europe. The current markets should also grow substantially. The profitable business will be there for the banks that hold the course.

How will the introduction of new markets such as Italy, Norway, Sweden and Finland affect the market?

Positively as local investors should become more involved if you use the experiences in France, Luxembourg, Spain, Ireland and the UK as a guideline. We saw in the UK, for example, some fund managers buying UK covered bonds for the first time because they could not ignore them for their indices. Once they purchased the local UK variety, they looked at the other markets for comparison to see if they achieved good value. The more they began to learn and understand these other covered bond markets, the more they began to buy non-UK covered bonds as well.

Does the UK need true legislation for its covered markets?

Existing transactions have demonstrated that covered bonds can be issued in the UK, and be recognized as such without dedicated legislation. Market acceptance in terms of pricing does not suggest there is a distinction between these bonds and bonds that enjoy a dedicated legislative framework, with UK issues trading at spreads comparable to other covered bonds. The benefits in terms of level of protection may not necessarily increase either, as the UK insolvency law already clearly favours creditors, and we have seen, for example, in Spain, some criticism of the creditor protection as afforded by the Spanish covered bond law. The key indicator is investor acceptance of the securities and how this may increase following a specific law. Obviously, a higher degree of standardization may be beneficial to the understanding of the products, but so far investor take-up on UK covered bonds seems to prove that they are widely accepted under the current framework.

Gaining liquidity and transparency – are the exchanges bearing fruit and the end users reaping the rewards?

There has been an increasing variety of issuers outside the traditional covered bond-issuing countries, and the placement of issues is tending to become more and more international. Liquidity and transparency are some of the obvious prerequisites for this expansion. For end users to reap the rewards, it is important that independent price discovery takes place, resulting from a large number of dealers quoting firm prices. EuroCredit MTS has brought these benefits to dealers, and in turn to the investor community, as quoted prices, central order book and executed trades are distributed via the data vendors. Established liquidity and transparency is extremely important not only for the trading of individual securities, but also in the perspective of building covered bond indices or other market indicators, which can be easily replicated because they are based on transparent, tradable prices.

Are EuroCredit MTS’s attempts to broaden its platform, by lowering the criteria for eligibility, good for liquidity and trading?

EuroCredit MTS expanded the list of eligible bonds to address market evolution. The market has evolved dramatically in the past couple of years, with individual issue sizes tending to reduce, but in no way altering their quality or the quality of issuers. EuroCredit simply adapted its listing criteria to reflect what are now the characteristics of benchmark covered bonds. This allows us to remain in line with the standards of the market. The other listing criteria have not been changed, and in particular, the minimum number of seven market-makers to guarantee liquidity remains for all issues.
In practice, this number is 10 to 15 dealers for most issues, with each dealer quoting for 10 million both sides. This means firm two-way prices are available for 70 million minimum at any one time, and in most cases for 100 to 150 million. This is true for issues of all sizes, and liquidity of newly listed issues has been comparable to larger issues, representing now 40% of EuroCredit MTS volumes. The liquidity of EuroCredit MTS-listed issues remains primarily assured by the fact that dealers choose the securities for which they want to make markets, and that for each security, the minimum number of market-makers is guaranteed.

How transparent is the market? Is more disclosure required?

The MTS group has been working to bring more transparency in all markets – starting with government bonds and subsequently with covered bonds and agencies. One of the keys to transparency is to have strong commitment from dealers to make prices and give liquidity to issues and issuers. This can be obtained when issuers and dealers commit to a liquidity agreement, whereby dealers agree to become market-makers and adhere to specific criteria, such as quoting a set number of bonds for a given number of hours each day. Such commitment must be monitored and is efficient because, by and large, dealers disclose their activity to issuers. In return, issuers commit to certain standards in terms of issuance size and transparency. In markets where this equilibrium is respected by issuers and dealers, liquidity builds up, spreads narrow, the cost of funding for issuers decreases and the investor base broadens. Disclosure is one of the pillars of the MTS model and issues that trade on the platform are as a result widely acknowledged to be more transparent and liquid.