Banks unfortunate enough to be lumped into the European periphery category have had a tough time funding since the continent’s sovereign debt crisis took hold. For those lucky enough still to be able to access wholesale markets, the cost of funding has blown out. But many others have been locked out of public markets altogether.
Covered bonds have provided succour for some of the banks that are unable to access senior unsecured markets, but it comes at a cost. A Portuguese bank is understood to have stepped back from proceeding with a covered bond transaction in February after investors indicated the trade would need to offer a pick-up to swaps in the 400bp range, for example.
Yet this is not the case for all. The countries in the peripheral category are diverse. At one end sit Greece and Ireland, which have already been bailed out by the European Union. At the other extreme is Italy, with high national debt levels, but a deep local investor base that cushions the country from the whims of international investors. And in the middle are Spain and Portugal. Described as "core periphery" by one Spaniard, Spain’s banks have sold cédulas hipotecarias this year without a struggle.
But Portuguese financial institutions have not fared so well: no Portuguese bank has tapped international markets for a year.
Over the course of the sovereign crisis, covered bonds have become increasingly important for banks in peripheral countries to access funding.
Affordable route
For many institutions that are either shut out of the senior unsecured market completely, or would only have access at prohibitively high levels, covered bonds provide an affordable funding route.
Data from Deutsche Bank shows that three-quarters of Spanish banks’ public bond issues in the first two months of 2011 were in cédulas format, up from less than 50% in 2010. Covered bonds accounted for 55% of Italian banks’ public issues in the same period, also an increase from last year. And across the eurozone, covered bonds made up around half of total bank issuance in the first two months of 2011, a historically high proportion, according to Deutsche.
Depending on how they are structured, covered bonds can benefit from higher ratings than those of the country they are issued in. That’s been a particular benefit through the sovereign crisis as a slew of downgrades have hit peripheral sovereigns. Most recently, Moody’s put Spain down a notch to Aa2 in early March.
With enough over-collateralisation, banks in these countries can get around the falling ratings, says Hélène Heberlein, managing director in Fitch’s covered bonds team. "Covered bonds can be rated above the sovereign, although certain caps are applied," she says. "For instance, Fitch rates Portugal A+, and Portuguese mortgage covered bonds can still reach AAA in some cases. Irrespective of this, issuers may choose to provide lower protection than the level of over-collateralisation supporting a triple-A rating."
Additionally, incoming banking regulations make covered bonds more attractive than senior unsecured for investors, says Clemens Popp, global head of financial institutions and sovereigns origination at UniCredit in Munich.
"This means the attractiveness of covered bonds, especially under Basel III, is tremendously increasing, and not just from a risk perspective, because they’re secured," says Popp.
"At some point the situation will hopefully improve for the banks that are currently unable to access the market. But we have Basel III knocking at the door, and this means that the funding future for most for these institutions has to be seen in the covered bond arena rather than in senior unsecured."
Varied appetite
Investor interest in covered bonds from peripheral European issuers varies sharply between jurisdictions. The sovereign curve is an important reference point for pricing transactions, so where that trades can be crucial, says UniCredit’s Popp.
"As an FI, if your natural benchmark, the sovereign, is at 1,150bp over swaps in five years and 800bp over in 10 years, as it is in Greece, that’s a clear no. You have no access on senior basis or on a covered bond basis.
"Portugal’s five year, a February 2016, is trading at plus 448bp. As in Ireland and Greece, as a financial institution you simply can’t afford to issue at these levels, even if there was demand — which I doubt with discussions around a sovereign rescue going on."
No Portuguese banks have issued public benchmarks in any format since the first quarter of 2010.
Popp says that Spanish banks, including second and third tier issuers, have access to covered bond funding. The third tier might have trouble issuing cédulas with a tenor longer than three years, but market access is there, he says.
The situation is different again in Italy, according to Popp. "The sovereign is and always was quite heavily indebted. But if you look at their five year spreads, the sovereign’s August 2016 is at 100bp over Euribor. This is more or less the natural benchmark for bank issuance.
"The country’s borrowers tremendously benefit from a strong national bid, be it on the sovereign or financial side. They have an incredible national bid for their own products. That’s resulted in a situation where Italy has avoided the turmoil of the financial crisis even better than neighbouring countries."
While covered bonds may be a viable funding source for peripheral banks, they do not come cheap. Spreads have widened considerably as a result of both the financial and the sovereign crisis.
Take La Caixa as an example. The Barcelona-based issuer sold a Eu1.5bn five year cédulas hipotecarias in May 2009 at 146.1bp over Bunds. The borrower sold a bond of a similar maturity at 262.7bp over Bunds in February 2011.
It’s a similar situation for Italy’s Intesa Sanpaolo. The bank paid 150bp over swaps in February 2011 for a 5-1/2year trade, a higher spread than it had paid for a seven year transaction in April the previous year, which came at 50bp over swaps.
It’s where you’re from that’s important
In today’s market, jurisdiction is crucial for pricing deals — just as important as the quality of the bank itself, says Popp.
"The Greek state is heavily indebted, but the core tier one ratios of the biggest institutions are much better off on a standalone perspective than many of their European peers," says Popp. "When you’re now on the road with a covered bond issuer, people want to know business model, the cover pool, and the rating — but first of all they want to know which country you’re from, and under which jurisdiction you’re issuing."
Despite the elevated returns demanded by investors, the risk of default is low for Spanish cédulas, says Alejandro Sánchez-Pedreño Kennaird, managing director, fixed income, at Ahorro Corporación in Madrid.
"I don’t see any cédulas going into default," says Sánchez. "And, should we have any going into default, I don’t see investors not getting 100% of their investment back given the huge over-collateralisation. The average over-collateralisation is 200%. To lose any part of the principal, you would have to have a price adjustment of more than 50% of the total mortgage balance sheet. Compare that with other jurisdictions, where they have just 125% over-collateralisation, which may not be sufficient if we see some distressed sales."
Sánchez says that, in Spain, banks are heavily provisioning their real estate portfolios, and have an average of 70% non-performing loan coverage. Although interest rates are set to rise, the gradual increases that are predicted are unlikely to affect the performance of Spanish mortgages, he says.
"The only thing with regard to NPLs that is slightly concerning is if interest rates go up very quickly, because most of the mortgages are floaters," says Sánchez. "It’s not a big deal if they go up 25bp or 50bp, but if they go up say 2% this year it could have an impact."