Covered bonds: dealing with migration

Once the domain of triple-A rated deals with bullet maturities backed exclusively by public sector or mortgage loans, covered bonds have morphed into a multi-faceted asset-class in which migration is now visible on many different planes.

Ratings have moved down the entire credit spectrum from triple-A to sub-investment grade. Collateral now includes small and medium sized enterprise loans, aircraft loans and even green assets are being considered. The structure has also shifted as hard bullet maturities have evolved to extendible soft bullets, and conditional pass-through maturities will soon be on the menu.

Change is inevitable but the preferential regulatory treatment must be nurtured and protected and the safety of assets must therefore be beyond reproach. This gives weight to the industry’s efforts to delineate the meaning of covered bonds with a labelled definition. 

Though mortgage and public sector assets will always be at the core, this does not necessarily mean investors will be excluded from buying SME backed deals that are issued by strong banks with a sustainable business model.

Nor does it mean investors will necessarily be obliged to buy labelled covered bonds from lower rated banks that depend heavily on central bank funding. Investors, who are presently starved of supply, will ultimately always call the shots.

The global covered bond market shrank by €55bn this year, and with deposit growth and bank balance sheet deleverage exerting negative influences, the market could shrink again in 2014. So unless there’s an unexpected breakthrough and US legislators enact a law that catalyses local supply, which seems unlikely, issuers will probably continue to test appetite for variations – but still with a covered bond theme.

The migratory nature of the asset class, therefore, seems set to continue.

Participants in this roundtable were: 

Andreas Denger, senior portfolio manager at Munich Ergo Asset Management (MEAG)

Attila Juhasz, principal portfolio manager at The World Bank

Florian Eichert, head of covered bond research, Crédit Agricole CIB

Hélène Heberlein, managing director and head of European covered bonds, Fitch Ratings

Joaquin Cortazar, portfolio manager, Banco Bilbao Vizcaya Argentaria Asset Management

Jozef Prokes, portfolio manager, BlackRock

Mariano Goldfischer, head of global debt markets, Crédit Agricole CIB

Ralf Burmeister, portfolio manager, Deutsche Asset & Wealth Management

Vincent Hoarau, head of FIG and covered bond syndicate, Crédit Agricole CIB

Yvan Lavastre, ABS and covered bonds portfolio manager, Caisse des Dépôts et Consignations

EUROWEEK: In what way are proposed covered bond regulations affecting the market? 

Ralf Burmeister, Deutsche Asset & Wealth Management: Solvency II and CRD IV are causing a regulatory-induced rise in demand for liquid and highly liquid assets from banks and insurance firms alike, but there can only be one price for one bond which must be paid by each and every investor. But we have to wait for the final wording and the way in which national authorities implement the EU guidelines, which may therefore justify a case-by-case approach to different countries.

Florian Eichert, Crédit Agricole CIB: It will depend on what the European Banking Authority comes up with. I think their ideal end case would be an ECB repo eligible database where they have a particular treatment and a particular haircut next to each bond. 

Attila Juhasz, World Bank: Covered bonds benefit greatly from proposed regulations and have an advantage versus the other asset classes. But I do see some risks in terms of the regulatory rating thresholds which are set as double-A minus. It means we will see a two-tier universe. The risk is that some investors move out of lower rated entities to buy triple-A to double-A rated bonds which may in turn squeeze prices higher.

Eichert, CA-CIB: Double-A minus is unlikely to be the material rating threshold. It could be set at triple-B minus, or there could be room for national discretion with, let’s say, Spanish banks being allowed to hold more lower rated Cédulas, while German banks are made to comply with a higher minimum rating threshold. 

It would be challenging to force a Spanish bank to pile into high rated French or Nordic covered bonds as this may mean they’re locking in negative margins which in the long run would hurt their capital base. I’m also pretty sure the EBA will take maturities into consideration. At the moment the Basel text merely mentions a flat haircut of 15% on all covered bonds rated above double-A minus. 

Mariano Goldfischer, CA-CIB: One of the most positive effects of regulation is the low capital charge that covered bonds attract. Bank treasuries have an excess of cash these days, which means they are more likely to favour the covered bond asset class vis-à-vis unsecured and other lower quality paper.

Joaquin Cortazar, BBVA Asset Management: We also have the opinion that CRD IV will be very beneficial for us in terms of the capital we will need to hold against covered bonds. But I would like to see a better capital treatment for MBS in which we also own a substantial portfolio.

EUROWEEK: Covered bonds are excluded from bail in, but there still seems to be a question over the residual unsecured claim and voluntary collateral?

Eichert, CA-CIB: Covered bonds are one of the only instruments where the notional claim is excluded from a bank’s resolution but there’s some variation to the wording of the proposals. Some versions say covered bonds, including all voluntary overcollateralisation (OC) and derivatives should be excluded from bail-in. Others say that only the collateralised claim is safe and anything in excess of that could be taken away. 

Juhasz, World Bank: My impression is that countries where the covered bond market is traditionally a very important funding market, such as Germany or France, will be keep covered bonds completely out of the bail-in resolution. But others where there is less of a history such as the UK may exercise more discretion when it comes to the residual unsecured claim and excess OC, so we will pay a lot of attention to this.

Hélène Heberlein, Fitch Ratings: Some countries like Germany already have restructuring laws that explicitly refer to covered bonds but others such as Spain do not mention covered bonds. We can be fairly certain that committed collateral will be safe but it remains to be seen what happens to excess collateral. 

There is also some question over the residual unsecured claim against the bankruptcy estate in case the covered bond collateral isn’t sufficient to redeem all investors. This in its credit analysis of covered bonds Fitch only looks at the cover pool and does not give credit to unsecured claim.

Yvan Lavastre, Caisse de Dépôts: When a bank is close to failure and where reputation or rating risks are less important, voluntary OC currently available in cover pools could be potentially reduced to the legal minimum. Unencumbered assets that are not included in the cover pool are valued on an accounting basis which might differ from their market value depending on their quality and/or liquidity.

Eichert, CA-CIB: The bank CFO is liable for protecting the unsecured investors and may feel compelled to reduce the OC to the legal or the contractually committed level before a bail-in becomes relevant. The important thing from an investor’s perspective is that the covered bond programme is not moved to the bad bank. Provided the programme remains in the viable entity of the bank after its resolution then any question about claims over the excess OC are almost irrelevant because you’re still with the part of the bank that’s writing business.

Burmeister, DeAWM: Bail-in has the aim and the purpose of preserving something within the bank which is worth being supported. So I would assume a residential mortgage-backed covered bond is something that’s worth being supported and would be included in the better part of the bank — in which case it’s rather academic to talk about the potential bail-in of the residual senior unsecured claim. 

If OC goes down following a bank’s resolution, that’s the price covered bond investors have to pay to get a healthier restructured issuer with a cleaner balance sheet. The introduction of Sareb in Spain didn’t automatically lead to a negative impact on the cover pools. OC went down, but asset quality improved so it’s give and take.

Jozef Prokes, BlackRock: The wording is very interesting because they say the secure liabilities including covered bonds are permanently excluded from bail-in, which sounds like the whole thing is out. But we’ve had a lot of rumours, discussions, push-backs, in terms of what happens to voluntary overcollateralisation and the residual senior claim. These two topics are still subject to further clarification, but the document reads in a way that suggests there is no benefit to messing with either of those two aspects.

EUROWEEK: Senior unsecured spreads have tightened considerably versus covered bonds but is this sustainable?

Goldfischer, CA-CIB:  If the environment continues to be favourable you will see more banks issuing unsecured than secured. And in present conditions there will always be a pricing issue between the secured and unsecured spread. One and a half years ago, there was no pricing issue as many banks were unable to access the market in unsecured format. 

Lavastre, CDC: The bail-in perspective will change the view of investors in the near future. The last tests from the European Commission showed a significant expected loss for senior unsecured investors in the event of a bank’s default. This has huge consequences for the pricing of senior unsecured debt and hence unsecured spreads will have to widen.

Burmeister, DeAWM:  The lower a bank is rated, the higher the spread should be between its covered bonds and its senior unsecured bonds. But this is a complex and heterogeneous topic that does not lend itself easily to generalisations. 

Cortazar, BBVA AM: The senior unsecured to covered bond spread will depend on the liability structure of the bank concerned. If the bank has less than 8% of loss absorbing debt below senior unsecured then the risk of a senior bail-in becomes material and should be reflected by a wider spread. 

Goldfischer, CA-CIB: Despite the recent risk of bail-in having decreased significantly from last year, the fact is that covered bonds are basically carved out of bank resolutions. This is very positive for the asset class and will exacerbate the gap versus unsecured in periods of turmoil, particularly for weaker banks.

Lavastre, CDC: Eurozone banks are vulnerable to fragile economic conditions and are still dealing with the recession. We think it’s more likely that covered bond spreads versus senior will widen. The stability of ratings on European banks and, consequently, on the covered bonds, is therefore likely to remain delicate.

Prokes, BlackRock: Much will depend on if the new bail-in rules are triggered and if they are, the senior market is potentially looking very expensive as an asset class, at which point borrowers could turn to covered bonds. But at current prices it makes perfect sense for banks to issue as much senior as possible. If I was a treasurer, that’s exactly what I would try to do.

EUROWEEK: Asset encumbrance has been grabbing the headlines or a while now but I’m not sure it’s such a negative factor from a covered bond investors’ perspective is it?

Andreas Denger, Munich Ergo Asset Management: It is only a problem insofar as there could be rating consequences. If a bank’s senior unsecured debt is downgraded due to the rating methodology then covered bonds might follow. But in light of bail-in rules, rating agencies should question whether the senior unsecured rating link needs to be so closely correlated or whether there is a case for increasing the notching span from senior unsecured to covered bonds.

Prokes, BlackRock: It doesn’t really matter from a senior bondholder’s perspective whether a bank has €100bn of unencumbered mortgages on its balance sheet or if it has €100bn in its covered bond programme. If there’s a loss it will get allocated in the waterfall starting with equity, subordinate debt and then senior unsecured.

An investor of a bail-in-able instrument should not necessarily be negatively impacted just because somebody has a priority claim on certain pool of assets — unless we speak about a good bank-bad bank split. Whatever loss was created by any of the assets on the balance sheet of the bank, its bail-in-able instruments are liable for. Period. 

Eichert, CA-CIB: Encumbrance is a problem for banks because it reduces their flexibility. We’ve seen hard issuance limits adopted in new markets while in Nordic countries where discussions have been taking place they’ve turned away from imposing hard limits. From an investors’ perspective encumbrance isn’t a major problem, the main thing that would happen is that issuance becomes restricted.

Juhasz, World Bank: It’s fair for regulators to have a soft limit of 20% of the value of assets on a bank’s balance sheet, or opt for a case-by-case approach, but I would not be happy to see a strict hard limit in the law because it’s less flexible and therefore harder to change. 

Heberlein, Fitch: We recently published a study that for the first time looked at encumbrance versus all of a bank’s assets, while previously we were looking only at covered bonds in proportion to its total liabilities. We found that 19 banks in our sample of 135 had a cover pool representing more than 50% of the total balance sheet and six were above the 70% mark. But nearly all of these highly encumbered banks were from the Nordic countries where covered bonds play a much bigger role in their business models. 

EUROWEEK: SME covered bonds don’t seem to be accepted as the real thing by many traditional covered bond investors but Fitch rated the Commerzbank SME deal as if it were a covered bond. Why is that? 

Heberlein, Fitch: I’m not in the business of defining what a true covered bond is. I’m in the business of saying which debt I analyse with Fitch covered bond criteria. In the case of the Commerzbank SME structured covered bonds we did analyse the programme based on our covered bond criteria because of the dual recourse structure against one financial institution and against a cover pool of assets.

Lavastre, CDC: SME covered bonds are structured covered bonds with unique collateral and therefore have very different characteristics from mortgage covered bonds. First and foremost SME loans do not benefit from the additional security offered by a mortgage loan that is backed by a specific claim on real asset. 

Heberlein, Fitch: Indeed, SME covered bonds are not Ucits compliant because none of the European legislations accepts unsecured SME loans as eligible collateral, but in Turkey for instance, the legal framework explicitly allows SME loans as collateral. From a rating agency standpoint, Ucits or CRD compliance doesn’t matter so much.

Lavastre, CDC: Top ratings will typically either require high OC or long soft-bullet/pass-through structures, as is commonly used in ABS, and SME covered bonds do not comply with Ucits or CRD and cannot get an ECBC label. 

Heberlein, Fitch: But in Turkey there is a legal framework which qualifies those bonds under the Ucits definition though clearly the assets do matter to investors from a capital weighting standpoint. But for rating agencies it doesn’t matter whether the covered bonds are compliant or not.

Goldfischer, CA-CIB: In my opinion SME collateral is more suited to ABS than covered bonds, unless the loans have a public sector wrap. But we have an undersupplied market and spreads are tight, so the asset class should benefit as, in general, people will try to grab the higher relative yield offered by this instrument. 

Burmeister, DeAWM:  I won’t be negative on SME secured bank bonds, as long as they’re not called covered bonds. In volume terms the ABS market is still far from recovering so one funding tool is still missing from banks’ toolboxes. If the SME structure can improve their funding situation, attract new investors and bring back old credit investors who used to buy ABS then these bonds could be a good thing.

But the point is they’re not covered bonds in the true sense. By definition, not all assets on a bank’s balance sheet can be the best ones. You would need specialist expertise to assess the quality of SME structures and that level of analytical proficiency is out of reach for most traditional covered bond investors. As the SME assets are short-maturing, turnover in the pool could be high which would mean that constant surveillance would be required. 

Prokes, BlackRock: There’s been a lot of turmoil in the market and banks always need funding, which covered bonds help with. But it concerns me when someone says this is a covered bond when it might have all the features. When the time comes, and a bank is facing a credit event, it is important to know where, as an investor, you stand. I’m happy to invest in labelled covered bonds that are priced correctly and where I can understand the risk. 

Eichert, CA-CIB: The credit quality of SME loans is still migrating south and issuers are less concerned about how to fund them than they are about their capital consumption. SME assets aren’t eligible for covered bonds under the capital requirement directive and I feel they’re better off being funded through ABS which the European Central Bank is keen to promote, as recently shown by their decision to reduce ABS repo haircuts.

Lavastre, CDC: And the SME covered bonds are now classified within the Eurosystem’s collateral framework, also leading to a lower haircut… finally a good surprise.

Juhasz, World Bank: They are recognised within the Eurosystem collateral framework but I don’t believe they are real die-hard covered bonds at this stage. SME bonds will have to stand the test of time over the long run, but in any case I see them as a hybrid instrument between an ABS and a true covered bond.

Cortazar, BBVA AM: We would analyse an SME structure if it was offered to us but in general we prefer to remain invested in mortgage covered bonds. 

Denger, MEAG: We should not risk the quality of the covered bond market by adding new types of collateral. Instead, one should focus on bringing back the ABS market. Covered bonds and ABS are markets which existed side by side before the crisis and that was not without reason. Now we have such low interest rates there should be a decent investor base that should be tempted to buy high quality structured products. 

Prokes, BlackRock: It’s very important that when you start talking about resolution and moving assets between a good bank and a bad bank that there is a clear vehicle of choice for the resolution authority. You can easily start arguing some of the collateral which could be presented in a covered bond pool might not be a core asset of the bank. There is therefore a risk that the introduction of new types of collateral risks diluting the preferential regulatory treatment that still benefits traditional covered bonds.

Burmeister, DeAWM: It’s questionable whether SME loans would get the same level of state sponsorship as housing loans. 

In Ireland and Spain for example, the national governments have taken measures to support their housing markets. So, in the absence a government’s protection of the SME sector, investors must develop greater trust and comfort in the issuing banks’ selection capabilities and their capability to judge the quality of the SME borrowers.

Heberlein, Fitch: Notwithstanding these concerns I assume we’ll see copycat SME covered bond structures being tested from other jurisdictions before long. 

EUROWEEK: There has been a fair bit of talk about green covered bonds but from my perspective it doesn’t seem to have amounted to much. 

Do you really think this is a market that has a viable long term future as a sub-sector of covered bonds, or would it be better suited to another asset class?

Burmeister, DeAWM: I wouldn’t want to prohibit any kind of financial innovation that makes our environment better but I’m not sure whether it fits in the covered bond structure per se because in my view this collateral is better allocated to project finance. There’s always a decent share of entrepreneurial risk if you were to invest, for example, in solar panels in the Sahara Desert or wind parks in the North Sea. 

Eichert, CA-CIB: There’s talk of using covered bonds to refinance improvements on houses to make them more energy efficient and there are discussions around how covered bonds could be used to refinance wind parks and solar parks. But at this stage the concepts seem to be more about marketing ideas than making concrete proposals.

Juhasz, World Bank: Green covered bonds are an extremely interesting concept and I’m curious to see how a pool could be put together. We’ll definitely pay attention to this sector. 

Prokes, BlackRock: For me this topic is more compatible with project finance and hence I don’t think I would have any reason to give any preferential pricing for a green covered bond over any other secured structure that is backed by assets that are not mortgages. 

Denger, MEAG: I would look at green covered bonds if everything was fine from a legal perspective.

Cortazar, BBVA: If they were offered we would of course analyse the structure, assets, legal framework and so on and then assess where we thought the spread should be. 

  

EUROWEEK: Tell me about the pass-through
structure.

Vincent Hoarau, CA-CIB:  In a pass-through, after an issuer event of default and after the maturity date of the relevant bond, or breach of amortisation test, incoming cashflows will be passed to covered bond creditors. The covered bond company of a pass-through structure will attempt to sell the mortgage pool but only if the bonds can be redeemed at par. This differs markedly from a soft-bullet structure where the pool has to be sold within the extension period, even if this results in a loss on the bonds. On the downside, investors of a pass-through structure could face a longer extension period compared to a soft bullet, but on the upside there is a greater probability they will be redeemed in full. 

EUROWEEK: NIBC could be about to market a pass-through structure that will be a lot more stable from a rating perspective and could offer hope to weaker banks in the periphery, but at the end of the day it’s still the same mortgages and issuing entity. Do you think investors could be tempted?

Goldfischer, CA-CIB: Issuers will argue the structure is better protected against rating migration but investors will be worried about extension risk. So the real question will be to see if issuers and investors can meet in the middle in terms of pricing. CRD IV compliance will be the game-changer. If the structure complies then, from a capital point of view, it becomes a lot more attractive in an environment where we have people looking for yield. 

  

Juhasz, World Bank: Pass-through structures will presumably be more immune from rating volatility, which is definitely good, but again I see this structure as a hybrid animal between ABS and covered bonds. We would definitely take a look, but there has to be a decent spread to compensate for the additional risk. The analytical framework will be different and that means the pricing should be different too.

Cortazar, BBVA AM: In the event a pass-through structure was presented to us, we would certainly look at it and try to assess where the right spread should be for this novel risk.

Burmeister, DeAWM: The pass-through helps issuers to reduce OC while at least keeping their ratings or possibly getting better ratings, so there’s some kind of rating arbitrage. It seems incongruous that the bond gets a better rating but may take years to fully repay. So therefore the pass-through structure is not something that I would welcome as I wouldn’t feel comfortable with the idea that I might not get my money until the debtors pay.

Hoarau, CA-CIB: Yet, I’m convinced that investors will accept pass-through covered bonds as long as issuers have the right marketing and pricing approach. Education will be key in the selling process. The pass-through offers two major advantages: limited risk of a disadvantageous fire sale of assets, in the event of the issuing bank’s insolvency and de-linkage from the bank rating. With more and more bonds on the cusp of junk, investors are getting increasingly rating sensitive, which makes this a key element. 

Prokes, BlackRock: As an issuer you may start to question whether to do an RMBS instead of a pass-through covered bond. The issuer should do an RMBS and not try to sell the covered bond more expensively to investors that will probably be forced to sell it if the pass-through mechanism is triggered. If I can price it, I can buy it, but I disagree with the notion that you should be happy as a covered bond investor simply because they have a better rating.

Lavastre, CDC: As a covered bond and ABS portfolio manager, I can consider pass-through covered bonds backed by prime residential mortgage loans. We will not be surprised to see new pass-through covered bonds in the near future. But we must keep in mind that pricing of these new covered bond structures, while potentially attractive for weaker names, must be reflected in the spread paid to the investor.

Hoarau, CA-CIB: I’m convinced that with some education, experience and a bit of spread premium investors will be won over. When Crédit Agricole helped to sell the Commerzbank SME covered bond, the pass-through element was not an obstacle.

When soft-bullet structures were introduced years ago many investors were reluctant to buy them, but today it’s barely taken into account in the investment decision process. 

Prokes, BlackRock:  I will need to be paid for the fact that I’m to take on the liability management risk of the issuer. Frankly it doesn’t give me any more peace at night that something is rated triple-A just because it’s now a pass-through, when before it was rated only double-A minus. I hold the same collateral and I hold the same issuer credit risk so what’s the benefit?

Hoarau, CA-CIB: In the end, the credit profile of the bank sponsor, the quality of the underlying assets, and the legal framework are going to be the decisive factors — not the structure of the maturity. NIBC’s structured conditional pass-through programme will very likely be the first to test the water later this year.

Prokes, BlackRock: I’m not opposing the idea. Having the right investor base for this type of product can be very beneficial. I quite like the idea that I can do more work on monitoring my cashflow and I’m not stuck in a bullet bond. But I’m also going to be demanding more spread for buying this compared to a hard or soft bullet bond from the same issuer. 

Denger, MEAG: I never say ‘never’, but honestly I guess it is more a pure rating benefit for issuers rather than something covered bond investors really need. I guess soft bullets have been more or less accepted and given some rating relief. 

Prokes, BlackRock: Pass-through is not a bad idea but it is being brought into the covered bond market for rating reasons. I don’t have a problem with a covered bond that morphs into pass-through on an issuer’s default, I just have to be paid for it. My concern is that it takes away some of the regulatory support, because it is almost impossible to call an event of default as the structure ensures there is virtually no asset-liability mismatch.

A good 80%-90% of traditional covered bond investors cannot hold RMBS. So they will have to sell the bonds in the event of an issuer’s default, which means potentially greater mark-to-market price pressure for these structures under stressed market conditions, so where is the benefit?

EUROWEEK: How do we feel about other non-traditional forms of collateral such as shipping or aircraft loans?

Lavastre, CDC: We can consider other types of collateral, but if they are not backed by a secured asset such as mortgages, we will at least need to be confident there will be a sufficient recovery and a direct claim against the issuer. Such instruments could provide good diversification at this time, when we see residential and commercial mortgage loan production declining and given that the sovereign crisis has reduced the leverage capacity of the public sector. However, we must be cautious with non-standard assets such as shipping and aircraft loans which are cyclical and hard to value.

Juhasz, World Bank: We have never bought ships or aircraft so far for several reasons. I think both markets are comparatively small, the risks are quite concentrated and they are both very cyclical with the global economy. We prefer residential mortgages collateral and we like public sector deals but only where the exposure is to the issuer’s own country. 

Denger, MEAG: Currently other types of collateral are better structured as ABS, but having being in the market for over 10 years now, I have learned that things can and do change, even in ways one doesn’t always like very much. Therefore, I would say, it depends how markets develop.

EUROWEEK: Bank deleveraging, a surfeit of central bank liquidity and falling loan production have affected the market, while regulations look likely to cement in a long term structural bid from the institutional side. How long can we expect this technically supportive backdrop to continue exerting its influence on spreads? 

Juhasz, World Bank: I suppose the situation may start to change as the ECB’s long term refinancing operation (LTRO) will run out at some stage and bank deleveraging will have to come to an end too. Added to which covered bonds are a preferred instrument in Europe and they are getting much more popular around the globe as we see lots of new countries approving legislation, so there will be additional supply. Maybe the European supply will be low but outside Europe this will become a very interesting tool.

Eichert, CA-CIB: We will probably see more peripheral banks being encouraged to test the market and raising the ECB repo haircut for retained deals is one way to encourage that, but they’re unlikely to issue the €70bn-€80bn that would be needed to bring net issuance into positive territory. The problem is that you have some pretty big sized entities that are in run-off mode, such as Hypothekenbank Frankfurt and the public sector programmes of German and Italian banks. That element of negative issuance is going to be around for the next 10 to 20 years.

Prokes, BlackRock: Since I’m not 100% sure the economy can take the pace of bank deleveraging I wouldn’t be surprised to hear, at some point, that the balance sheets of banks need to increase again to increase lending in the real economy, otherwise we’re all in for painful times. There are a few signposts suggesting that regulators are getting more open to the idea that banks need to grow their balance sheets in specific areas. If you clean up banks’ balance sheets but the economy collapses, nobody wants that. It’s already very bad with zero growth but what if we get a large European-wide contraction in growth?

Denger, MEAG: The market is already undersupplied with so called high quality bonds. Deleveraging and central bank liquidity is likely to drive investors into other types of bonds or direct investments. If the market regains trust in the euro periphery, the lack of high quality bonds should have a very positive effect for covered bonds from these countries.

Cortazar, BBVA AM: It’s clear that banks are prioritising issuance of loss absorbing subordinated debt to try to protect their senior debt, while at the same time they are trying to lower their leverage ratios. This unfortunately means that covered bond supply is likely to remain low for the foreseeable future.  

Goldfischer, CA-CIB: Mortgage origination has slowed in line with the macroeconomic environment, so I don’t think the undersupply of covered bonds will be corrected in the near future. As the market normalises most banks will want to preserve their collateral just in case there’s a new bout of volatility.

Eichert, CA-CIB: Even if the pace of issuance picks up later this year it will still be net negative to the tune of about €40bn by the end of the year. Over the next two to three years we’ll reach a redemption plateau of around €150bn which means that even if we pick up issuance from current levels, it’s likely to be a long time before we reach net positive issuance.

Hoarau, CA-CIB: The start of the US covered bond market could be a game changer but it has been under discussions for years and I don’t see it coming shortly.   

Lavastre, CDC: Today power is in the hands of issuers. With the economic crisis, the drop in bank lending and the excess of liquidity provided by central banks, issuers do not require significant funding and it looks like the market will remain undersupplied, which has obvious consequences for spreads.

Prokes, BlackRock: It will be very important to see when and where we get the first wobble in the senior market, in terms of senior investors in small banks being bailed-in for example. At that point we will potentially see senior risk being repriced which may cause a return to covered bond issuance. So at some point we will start to see healthier covered bond supply — possibly in the next couple of years.

Denger, MEAG: I don’t think we’ll see spreads return to the widest levels unless the market judges that the eurozone is going to collapse. In terms of performance potential from current levels I imagine that we have seen the lowest yields for countries like Germany but for the peripheral nations we may well see a further fall in yields.

Lavastre, CDC: I also think we have reached the tightest level spreads can go. With the loss of sovereign support and the prospect of bank downgrades, the impact of bail-in which could take effect in near future, spread levels could increase before the end of this year.  

Hoarau, CA-CIB: A prospective SSA widening could also drag covered spreads wider as holders take advantage of relative value and switch into agencies.  

Prokes, BlackRock: I’m quite happy to use any prospective weakening to add some covered bonds exposure to the funds, especially since I think we will ride this year out with a negative supply.

Cortazar, BBVA AM: European interest rates are likely to remain low for around three years so the risk of a European rate rise is more a long term consideration. My main concern relates to the impact of the Fed’s action on European markets. 

EUROWEEK: On the other hand, Europe isn’t exactly in a fundamentally strong place and if serious doubts about the viability of the monetary union resurface I guess all the technical arguments for spreads to remain tight can all get thrown out the window?

  

Hoarau, CA-CIB: Now and again volatility will return just when people forget about the fundamentals and valuations get too irrational. When I heard about the city of Detroit filing for Chapter 9 bankruptcy protection I wondered how many cities or regions in non-core Europe could find themselves facing a similar situation. 

Access to wholesale funding in senior unsecured format has been shut for most second tier peripheral names and their reliance on the ECB for funding is still far too high. And it doesn’t bear thinking about how many smaller banks will be able to meet their capital requirements. 

You have to ask how long this situation is sustainable when you don’t see any sight of economic recovery and when unemployment rates are rising to record highs every month.  

But if things start to get bad I don’t think the ECB will hesitate to consider a third LTRO, which would be a game-changer in Europe.

EUROWEEK: Does it concern you that we might soon be seeing a reining back of central bank liquidity?

Juhasz, World Bank: It is quite unusual in a normal environment to see all the asset classes moving in the same direction at the same time. So it would be healthier in the long run to see central banks decrease quantitative easing. When this occurs it should help to improve supply and ultimately it should improve yields. Though QE withdrawal is negative from the market’s perspective, in the long run I think this is the only way to go.

Goldfischer, CA-CIB: If for any reason the central banks start to ease off the liquidity pump too fast, and they make a mistake on reading the economy then we might have a problem. Basically, the global economy used to be in the emergency room and to some extent still is because it still depends on the excess liquidity of central banks, particularly in Europe. 

Denger, MEAG: Recent changes in the ECB’s repo haircuts could be a sign that central banks are starting to look more closely at the effect of their liquidity provision. I believe that central banks will act very consciously to decrease liquidity but only if the markets can withstand it. But if markets react badly to the withdrawal of liquidity I believe that central banks will be ready to renew the existing facilities or even increase them.

Burmeister, DeAWM: Withdrawal of central bank liquidity will be done step-by-step rather than in one go. But it’s something that the market will have to deal with. The US could start to withdraw liquidity by the end of this year and market participants will just have to deal with it. It is going to happen anyway because obviously this is not something that can go on for years and years.

Cortazar, BBVA AM: But I still think the ECB will remain on standby to provide liquidity if it is needed and for as long as necessary. The economic cycle in Spain, Italy and Europe in general is very different from the US which is now starting to return to a growth path. 

Lavastre, CDC: We expect the market to digest the more hawkish FOMC statements first and watch to see what the impact will be on European periphery yields before new issuance is seen.

Hoarau, CA-CIB: At some point the ECB will start to restrict liquidity and, after a powerful rally, market participants are likely to take profits and favour cash or very short term investments with a potentially devastating impact on the capital markets. But I don’t see that happening soon in Europe because the economic fundamentals don’t justify it and the situation isn’t likely to change in the near future.

Cortazar, BBVA AM: We see little value in investing in the core covered bond markets as spreads have become too tight. Though spreads have come in a long way in Spain and Italy they remain quite wide versus Germany and core Europe. But reforms are on the way and they will be implemented, which means over the longer term that spreads still have room to perform versus the core. A lot of challenges lie ahead but I think the worst is behind us so I am relatively positive on Spain.

Denger, MEAG: Taking into account the willingness of politicians and central bankers to strengthen the eurozone, current levels do not show the wrong picture. But the confidence to invest is all about trust. As an investor you need to make your judgment as to whether you are playing for the survival or death of the eurozone as it is currently set-up.

Goldfischer, CA-CIB: As things normalise you will continue to see covered bonds perform, but this will be more a function of the overall market than anything else. I think we have reached a relatively tight level, but in the case of the periphery, I think that spreads will continue to tighten. 

Eichert, CA-CIB: Some of the peripheral bonds like Bankia or some of the multi-Cédulas are still very wide. And even if you take into account higher than expected pool losses or the increased probability of the bank’s default, you still come up with a positive expected return so leaving out technical factors and rating considerations, there’s a strong case for convergence between core and peripheral markets.   

Burmeister, DeAWM:  Economic fundamentals have always been a little in the background due to central bank liquidity. Though this situation might last for a while longer things can change very quickly so I wouldn’t dare to say the periphery has completely decoupled from fundamentals.

Goldfischer, CA-CIB: It’s true that Spain will not dig itself out of its economic problems for quite some time. But if the economy doesn’t worsen and it’s able to stabilise, I think people will go back into the periphery. And as they get more comfortable with covered bonds, they will rally so I’m also relatively constructive.

Lavastre, CDC: Our feeling is that the rally was too quick and has come too far. Even though we have seen some technical improvements, the economic fundamentals are often bad: unemployment rates are at their highest and non-performing loans are still increasing.

EUROWEEK:  Do you think there are catalysts for a renewed spread volatility?

Juhasz, World Bank: We also see some black clouds gathering over Europe in Greece. I wouldn’t be surprised if we will again see a massive flight to quality leading to a Bund rally. I think the problem will come not from the banks or covered bond pools but mainly from the sovereign markets.

EUROWEEK: How do spreads affect your asset
allocation? 

Lavastre, CDC: The current level of yields and tight spreads are penalising covered bonds versus govvies or other riskier assets. When we look at French covered bonds versus OATs we see little value and we are then compelled to change our portfolio allocation.

Juhasz, World Bank: For me the basis swap is very important as I have to look at everything from the dollar perspective. So even if European yields start to rise it does not necessarily mean that from a dollar perspective I will be better off. Actually, the basis swap could tighten much more, in which case I would be earning less. 

Denger, MEAG: In current market conditions the portfolio allocation reflects a higher risk tolerance and higher yields at the short end and a lower risk with lower yields at the long end. In other words, we invest in covered bonds with higher spread volatility at the short end and bonds with lower volatility at the long end.

Juhasz, World Bank: The relative yield advantage of covered bonds, and especially core European covered bonds has declined, the proportion of covered bonds in our portfolio has declined as well.

EUROWEEK: What’s your strategy for coping with a potential rise in interest rates

Prokes, BlackRock: I wouldn’t be surprised to see the ECB becoming more dovish, to at least keep the front end in check. In reality we’ve had one rate hike already given that the Schatz went from zero to almost 25bp. So Europe is in a far worse position than the US to weather the emerging market and Asian slowdown, which means the Bund yield is not going significantly higher.

 

Denger, MEAG: It’s important to have a good balance of liquid investments in mid to longer maturities with higher yielding and less liquid bonds focused more at the short end as I can more easily hold these until maturity and replace them with new investments.  

Prokes, BlackRock: I’m not anticipating a collapse in risk assets, but we could see some widening in a very, squeezed market but nothing too dramatic. I’m quite positive on the market overall for this year. If Bunds go to 2%, does it mean we will see a collapse in covered bonds senior spreads? Not really.

Juhasz, World Bank: As we have to swap our exposure to three month dollar Libor constantly, our interest rate risk is low. On the other hand, in a rising interest rate environment, swap spreads by default usually widen which has an impact on the relative value of the covered bonds so they might relatively underperform. So from a duration and interest rate perspective, we are okay but from a credit risk perspective we may see widening which we will try to hedge with additional swaps.

Prokes, BlackRock: With regard to the Fed’s tapering, the genie’s out of the bottle. But if you look at the global growth prospects there are still some headwinds. We may well see an emerging market slowdown in the second half, which could well weigh on the Fed’s thinking. 

EUROWEEK: What’s your view on price discovery during bond syndication and pricing? 

Denger, MEAG: I accept that it’s a seller’s market I find it a bit frustrating to see deals price so far inside the initially indicated spread level. Initial price thoughts are there to help investors to decide whether or not to participate in a deal and IPTs provide the basis for investors to assess the relative value of a deal. If the final spread ends up being far away from the IPT, the valuation work investors put in to begin with is wasted. So I would like to see deals being marketed and priced within a specific spread area.  

Bank syndicates also could do themselves a favour and cut back on order inflation by simply starting with a more realistic and invariably tighter spread. Added to which, I would like to see investors more resolute in their initial value judgments, and be more prepared to turn away from a deal if the spread does not meet their target.

Hoarau, CA-CIB: I realise that some trade or switch ideas are killed during the bookbuidling phase because guidance is tightened between opening and closing the book and this makes many investors unhappy. However, we must also represent the issuer’s interest, and if there is an extraordinary demand in the book within the fixed price range, we will be obliged to revise it formally and test the investors’ appetite at a tighter level.

So I would support the idea of a fixed spread range providing that some conditions are respected. I would welcome less opportunistic investor behaviour, less inflated orders and more limited discrimination during the allocation process — which is triggered by big real money investors systematically asking for their orders to be protected which is often at the expense of smaller end accounts.

Should market practices evolve to a fixed spread range, it goes without saying that limited orders that are amended to the re-offer during the bookbuilding will suffer a disadvantageous treatment during allocation.

Eichert, CA-CIB: Covered bonds should be anchored to the issuer rather than the unsecured rating. The link to the issuer exists because covered bonds need a sponsor that is there to support the programme. With bail-ins of senior unsecured becoming possible we could have the situation where senior is bailed in but the bank continues to support the covered bonds. Unsecured is therefore not the correct starting point anymore. Rating agencies will have to rethink the way they award bank ratings with de-linkage between senior and issuer rating, and covered bonds being linked to the issuer rating. 

This should mean that covered bonds don’t move as drastically as they are moving at the moment. The problem is simply that agencies are not going to move before they have a final resolution framework text. Some peripheral bonds could thus be downgraded to junk only to be upgraded again later when the agencies eventually get round to changing their methodology.   

EUROWEEK: Are the rating agencies too strict? 

Juhasz, World Bank: You can argue it both ways but from an investor’s perspective, I prefer stricter scrutiny from the agencies.

Denger, MEAG: Stricter rating methodologies are more justified on the unsecured side given the impact of bail in regulations than they are on the covered bond side given their exclusion from bail-in.

Heberlein, Fitch: Our latest criteria change was in September 2012, it became not so much stricter, but more specific. We’d been downgrading covered bonds in line with the sovereign crisis for systemic reasons, but the criteria were initially developed at a time when European sovereigns were very stable. So when this was no longer the case, the criteria had to be clarified. In a way it’s not so much that the criteria became stricter, it became more explicit regarding the influence of systemic risk. 

Systemic risk is perverse because it affects several parameters at the same time. Bank ratings go down, interbank liquidity dries up, and as macroeconomic conditions deteriorate, cover pool performance worsens both from a probability of default and loss given default perspective. This means there is downward rating pressure on the covered bonds from several sources.

Lavastre, CDC: The credit rating agencies take account of the covered bond market’s dual recourse structure in their rating methodologies and use the issuing financial institution’s unsecured liabilities rating as the starting point and floor for their covered bond ratings. So without an implicit support from the sovereign, banks should be downgraded.

Cortazar, BBVA AM: I would like to see rating agencies become more transparent and believe they should try to simplify their rating methodologies, not just in covered bonds but across other asset classes such as MBS. The fact you often see very different ratings for the same deal shows just how complex ratings have become. I would like the agencies to co-ordinate their approaches and try to qualify why they arrive at different ratings.        

Eichert, CA-CIB: S&P views multi-Cédulas like a CDO and prefers to see a bigger liquidity line the greater the concentration of underlying entities. But what they’re completely ignoring is that the bigger entities are actually better rated than the smaller ones which are more likely to default. They look pretty closely at the biggest individual exposure and assess how large the liquidity line needs to be relative to that. It doesn’t make any sense.  

On the swap counterparty side the outcome could have been a lot worse than it actually has so the market may have dodged a bullet there. But they’re still overdoing it as counterparty risk is something that should be dealt with through OC and not through linking covered bonds to another entity.

Heberlein, Fitch: We do differentiate between the swap provided within the banking group and that which is provided by a third party. Because covered bond swaps tend to rank pari passu with covered bonds, investors could be at risk should a termination payment be due post issuer default. Termination payments could put a drag on liquidity, as the cover pool would need to pay the market value of the swap at a specific point in time, or else this would cause a cross default.

But it’s notable that Spanish programmes never had privileged swaps. The two recent Belgium programmes also have no registered swaps. They have fixed and floating rate assets and fixed rate covered bonds — but no swap in between. That makes it easier for issuers, but it also means there is more interest rate risk, which leads to comparatively higher break-even overcollateralisation for a given rating.

EUROWEEK: The rating agencies regularly update and tweak their assumptions but do you think they should change their methodologies that often? 

Juhasz, World Bank: They definitely have to because the market is dynamic. We have new asset classes, for example, these SME covered bonds, we have new regulations and the market landscape is always changing. So the agencies have to follow these developments. They shouldn’t be behind the curve but I’m not sure that they have to be ahead of the curve either. 

Burmeister, DeAWM: We are in a difficult economic environment and therefore ratings are likely to go down, that’s fair enough. But I sometimes find it difficult to understand some rating actions, especially when agencies don’t keep to their own methodology. For example, we have seen occasions where Spanish covered bonds were not downgraded to the extent they should have been in the aftermath of the sovereign’s downgrade. And in the case of the UK’s Co-operative Bank, Moody’s raised its Timely Payment Indicator so the bank’s covered bonds would remain investment grade even though they downgraded the bank to Caa1.

Heberlein, Fitch: Formally we review our criteria annually but that does not necessarily mean we decide on changes, though we are always considering adjustments in terms of stressed assumptions, such as for cover assets default and recovery expectations. Larger changes in the framework are less frequent. For example in 2009 we reassessed liquidity risk and gave more weight to the liquidity gap section of the Fitch discontinuity factor. 

This was tweaked in September 2012 when we replaced the discontinuity factor with a discontinuity cap. The D-factor gave the impression it was a very scientific measure, whereas in fact it was a qualitative judgement expressed in a quantitative way. Now we say the same thing in the form of notches. But this was more of a cosmetic change, the main change was the integration of systemic risk consideration as part of the liquidity gap assessment.

Lavastre, CDC: We need stability in methodologies as otherwise it means investors don’t have the possibility to make investments with ratings evolving continually.

Prokes, BlackRock: Many rating moves can be anticipated though some are surprising and sometimes even in a positive way. And if you are holding a covered bond that is prone to go down to sub-IG, it’s daft to say you didn’t see it coming. Sometimes the moves are surprisingly positive, sometimes they are surprisingly negative, but the volatility is quite well defined.

Denger, MEAG:  If the market shows significant change then methodologies should be updated to mirror the current picture. But downgrading unsecured bonds due to the increased risk of bail-in and not reflecting these changes in covered bond ratings, which are excluded from bail-in, is not a good thing. Agencies should think of the anchor for covered bond ratings.

Prokes, BlackRock: Rating agencies should update their methodologies as often as they like, I have no problem with that. They are a useful resource for investors, but that’s where it, many times, stops. There is a value when I look at a core market in terms of the information I get between a triple-A and a double-A rated covered bond but when I look at sub-investment grade covered bonds, I don’t think there is any new information that I can get from the rating.

The way bail-in seems to be playing out, it should make some rating agencies consider ways of delinking the covered bond rating from senior rating. One way they could achieve that is to look at the deposit rating of the institution, or if they don’t want to change their methodology completely, adjust some assumptions behind the senior to covered rating uplift.

What bail-in tells me is that you should see a wider notching for a very distressed institution such as a peripheral bank which is rated single-B on the senior side and double-B on the covered bond side.

But for large systemically important banks in Europe’s core there should be much less of an impact because the probability of the issuer defaulting is likely to be low. 

Burmeister, DeAWM: Agencies need to update their methodology from time to time but on the other hand they need to show comparability and consistency over time and over the rating cycle. If the methodology changes often it’s difficult to make a dependable assessment over a period of time. I don’t mind if they change some parameters, such as the assumption with regard to loan losses, but you have to start questioning what happens to consistency and comparability when the methodology is changed again and again.

Lavastre, CDC: Some countries are more affected than others by the European crisis. The peripheral countries are likely to struggle with high unemployment which is not sustainable. They will have to reform their labour market and find new ways to stimulate growth.

EUROWEEK: Does the evolution of the housing market or employment trends in any parts of Europe give cause for concern?

Cortazar, BBVA AM: The rate of unemployment is correlated with house prices and I believe, as far as Spain is concerned, that we have reached the high point in unemployment. We have already seen some falls but it will be a long, slow road to implement the necessary reform and to get the structural rate of unemployment down. I would also like to see more effort made to channel credit to Spanish SMEs which have the best potential to create jobs. But the main focus right now is on stabilising the financial system. When our banks are well capitalised, credit should start flowing to Spanish small to medium sized companies again, but the process will take time. 

Heberlein, Fitch: Spain is where we have the highest expectation in terms of a peak to trough decline in house prices. In nominal terms we expect to see a 40% decline from the peak in Q1 2008 and we don’t expect it to reach he bottom until the end of 2014. In the Netherlands we expect a peak to trough decline of 25% but they’ve already fallen by 18%.

We also follow government housing policies as governments will naturally try to avoid the social unrest linked to massive default and house repossession. They can impose restrictions on eviction for vulnerable borrowers. For instance in Spain there’s been some temporary measures announced and we have extended the recovery timing for defaulted mortgage loans from 36 months to 45.

Eichert, CA-CIB: The Dutch market is one of the worst-performing housing markets in core Europe but that hasn’t effected spreads one bit. They’ve actually tightened as prices have fallen. And all the nervousness about Nordic markets hasn’t had an effect. So I would say there’s been absolutely no impact in the core space.

Even if you look at the Spanish sector you would need to have a pretty drastic scenario to cause losses. The bigger risk you run is being extended rather than actually being hit with principal losses.    s