Issuers look at cover pools beyond mortgages

Though they make up only a small portion of the overall market, issuer appetite for financing non-traditional or non-mortgage assets via covered bonds is growing. Covered bonds “can be an interesting tool to take assets that had no real use before and use them as covered collateral and to improve your cost of funding,” says Christian Klocke, a FIG syndicate banker at DZ Bank in Frankfurt.

Mortgage-backed deals make up the bulk of covered bonds, with 90% of outstanding paper at the end of 2023 secured to these assets, and 8% secured against public sector loans, according to data from the European Covered Bond Council (ECBC).

“We want to make sure there are anti-cyclical funding mechanisms in place, meaning that the market remains open even in times of crisis,” says Luca Bertalot, general secretary of the ECBC.

However, cover pools lack diversity. For instance, the high concentration of risk linked to commercial real estate in some issuers’ pools has alarmed some investors, leading to elevated spreads and lower demand for the bonds.

Pools of alternative collateral could allow investors to diversify their exposure and pick up extra spread to compensate for the different regulatory treatment. “When portfolio managers are being asked questions by their risk departments about commercial real estate exposure, given that shipping is at a different point of the cycle, it could be a positive way to diversify,” says Martin Linderstrøm, head of treasury at Danish Ship Finance.

Using non-standard assets in a cover pool is nothing new. Two European issuers — Hamburg Commercial Bank and Danish Ship Finance — regularly issue benchmark-sized deals secured against commercial shipping loans under German and Danish covered bond law. Meanwhile, issuers in Germany have previously printed Pfandbriefe secured against aircraft loans and public sector lending for rail infrastructure. Outside the European Economic Area, Swiss car lessor AMAG Leasing has issued structured covered bonds secured against auto loans since 2021.

Whether to fund these asset pools via covered bonds comes down to cost. “It’s a competitive advantage for us to use the cheapest source of funding we can,” says Linderstrøm.

“For AMAG, a structured covered bond is about 40bp-50bp tighter than a triple-A rated ABS deal,” says Matthias Ogg, head of special products at Zürcher Kantonalbank (ZKB).

“Although there was a cost initially to set up the covered bond programme, the running costs are lower than for ABS,” says Ogg. “Covered bonds are cheaper from a financing and an ongoing maintenance point of view.”

When it comes to their pools, Danish Ship Finance and AMAG could not be more different to each other as well as traditional real estate lenders. One secures its debt on large, single loans, while the other is highly granular.

“The only major difference is that our ticket sizes are a lot larger [compared to real estate], meaning that our concentration limits are different to real estate lenders,” says Lars Jebjerg, CFO of the Danish lender. “We have a target set of clients of less than 200, whereas mortgages will have hundreds of thousands.”

In early 2024, Danish Ship Finance had a Dkr32bn ($4.8bn) loan book split across 596 vessels. However, the borrower does not use all these loans for their cover pools. The issuer’s euro covered bond pool, for instance, only contained 90 loans totalling the equivalent of Dkr8.9bn at the end of 2023.

The company allays concerns over concentration by running a highly conservative cover pool. “We have a 70% [loan to value] limit, falling to 60% for our euro programme, which is lower than many real estate programmes,” says Jebjerg. “We pre-fund our loan commitments, so we don’t run any refinancing risk.”

AMAG’s auto loan portfolio, on the other hand, “is about Sfr4.7bn ($5.6bn), with over 100,000 contracts,” says Ogg. “The beauty of auto loans is that they are a lot smaller, resulting in a more diversified pool.”

“Auto loans typically have a four year tenor and there is the possibility for pre-payments, which are more likely than with mortgages,” Ogg adds. “Mortgage loans can be up to 10 years in length, and so the average tenor is longer, and less replenishment is needed.”

However, “what is important is that the issuer has enough liquid assets that can support bondholders,” says Lindstrøm. “The crucial point is if you have what constitutes a sellable asset.”

Unfortunately for issuers thinking of using their non-traditional assets as collateral for a covered bond, regulations that tightly define the credit quality of covered bonds limit the audience for these deals in the eurozone.

Under Article 129 of the EU Capital Requirements Regulation (CRR), compliant covered bonds can only be secured on mortgages below a certain LTV ratio that are regularly valued, or guaranteed public sector loans. These deals receive preferential capital treatment for investors and are considered safer.

But the EU Covered Bond Directive opened the door to other assets beyond those allowed under the CRR. Though bonds backed by these assets would not have the same preferential treatment as CRR-compliant ones, they could still benefit from the European Covered Bond label — an industry hallmark devised by the European Mortgage Federation and the European Covered Bond Council. Covered bonds that also meet the requirements of Article 129 carry the European Covered Bond (Premium) label.

However, “many jurisdictions have not transposed the Covered Bond Directive and regulations to include programmes backed by other asset classes,” says Elena Bortolotti, global head of covered bonds and head of structured solutions, EME at Barclays. “Such deals wouldn’t be classed as part of the European covered bond premium segment.”

Of course, that does not prevent issuers from attempting to use non-standard assets as covered bond collateral. For instance, Luxembourg established a legal framework for covered bonds secured against renewable energy loans in January 2018, which was later used by NordLB Luxembourg to raise €300m in early 2020. However, the assets concerned did not comply with the needs of the CRR.

“The transposition of the directive seems to have stopped any structured covered bonds, at least in Europe,” adds Bortolotti. “Of course, you can have the big UBS/Credit Suisse-type structure, but I can count on one hand how many there are. The fact is structured covered bond issuers must pay up and appeal to a different investor base that doesn’t care about LCR [liquidity coverage ratio] eligibility.”

“The bottleneck is not structuring — I think that’s easy, as everybody knows how to structure a non-standard covered bond — or rating, rather the bottleneck for these projects is the investor base,” says Klocke.

Even if a structured covered bond were to offer 5bp-10bp more than a legislative one, investors would not buy them if they did not fit into their portfolios or mandates, Klocke adds. “These regulatory disadvantages prevent many traditional investors from buying. This is something that we’ve also seen in the Japanese structured covered bonds or the UBS Switzerland deals.”

For instance, bank investors took only 18% of UBS Switzerland’s €1bn 3.304% March 2029 structured covered issued on February 27, compared to 46% of Iccrea Banca’s €500m 3.5% March 2032 note sold on the same day. In the end, 59% of the UBS deal went to asset managers.

Of course, these deals are not for every investor and the inflexibility of covered bond legislation hinders the growth of the sector. However, regulators believe that the development of a new asset class — the European Secured Note (ESN) — could bridge the gap.

“The ESN would be a new funding tool with all the characteristics of covered bonds, albeit with non-traditional assets,” says Joost Beaumont, ABN Amro’s head of bank research.

The idea of the product is to take the well-established covered bond structure and use it to channel funding into parts of the economy untouched by traditional covered bonds. An ESN would, like a covered bond, have a dual-recourse structure, meaning that investors would have a claim on both the collateral and the issuer in the event of a default.

“Issuers are interested, but at the same time they do not want to be the first if the regulatory treatment is unclear,” Bortolotti says. “If a new instrument were to be developed, it is important there are minimum statutory requirements coupled with regulatory recognition.”

Though ESNs could in theory be used to fund any cover pool assets, the focus would be on financing small and medium enterprises. According to the European Commission, SMEs make up 99% of European businesses and employ more than 85m people. Financing these businesses is a priority for the European Commission. Such an instrument could help to green the sector too.

“Covered bonds or a similar dual-recourse instrument could be the answer [to funding the green transition], if they are harmonised or functionally simple enough for investors to feel comfortable,” says Bertalot. “The reunification of Germany was funded by public sector Pfandbriefe and, today, these bonds could be a key pillar for rebuilding and greening infrastructure across Europe.”

Issuers have previously experimented with SME funding using structured covered bonds, but investors never truly warmed to the product. For instance, Commerzbank launched a €5bn structured covered bond programme backed by loans to SMEs in 2012. The German lender only issued one deal off the programme — a €500m 1.5% February 2018 note — before choosing to focus on its mortgage and public sector Pfandbriefe instead.

“SME-backed ESNs are a possibility, but SME funding is already possible in well-functioning ABS markets where investors are already comfortable or familiar with SME or auto-lease securitisations,” says Beaumont. “The fact we haven’t seen any auto ABS issuers [in Europe] look at covereds might signal that it’s not economical to do so.”

“What’s the benefit [of ESNs] for investors if they already have billions of covered at attractive spreads to choose from?” asks Klocke. “What real added value does this different asset class bring?”