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Strength of covered bond market assured as global popularity spreads to countries such as Mexico Back  
From their origins in 18th century Germany to their current international profile as the safe financing instrument of choice, covered bonds are enjoying a surge in popularity. Ted Lord and Eldar Mezbur look at how economic developments and increasing sophistication are spurring the growth of the covered bond market.
Covered bonds originated from a need for a safe financing instrument which could attract funds in times of bad economic climate. The first pfandbriefe were issued in Germany in 1769 after the War of the Austrian Succession and were secured on property.

In the mid 19th century pfandbriefe were issued by public law credit institutions. Not long after the first pfandbrief, Denmark created its own covered bond when in 1797 the first mortgage credit institution was established with the purpose to provide people with loans to rebuild their houses destroyed by the great fire of Copenhagen. The first mortgage law in Denmark was established in 1850. Over time more jurisdictions recognised the efficiency of the covered bond instrument to finance relatively low risk assets, and covered bond frameworks have been established all across Europe.

The latest covered bond instruments are the structured covered bonds, instruments created within the general legal framework. While in most countries specific legislation is needed to ring fence assets from the general insolvency legislation, in certain countries like the UK, the general legislation is sufficiently creditor friendly to allow ring fencing without the benefit of specific legislation.

Characteristics of the covered bond market
Covered bond instruments are issued directly from the balance sheet of an issuer with priority recourse to low risk assets which are mainly loans to public sector institutions or mortgage assets. The term of covered bonds varies between three and 30 years, but the main issuance is seen at five, seven and 10 years, providing long term financing for the issuers. Covered bonds are generally euro denominated at a fixed rate and are considered by many market participants as gilt-edged securities. Certain jurisdictions acknowledge the reduced risk compared to unsecured issuance and apply a reduced risk weighting between government and bank risk weightings. These characteristics make covered bonds an important hedging tool for the swap markets and supply of covered bonds is an important driver of swap spreads.

Geographic reach is expanding
The first covered bonds in Germany and Denmark were sold domestically. Cross border marketing was limited, mainly because of currency risk. The arrival of the euro opened up the European covered bond markets, and the popularity of covered bonds both for issuers and investors has increased significantly. The Spanish market has attracted widespread investor interest and the outstanding amount has reached €94 billion. Two Austrian benchmark issuers have expanded their investor base into Asia and new covered bond markets have started to develop. A Hungarian issuer has brought one issue to market and is already preparing a Euro denominated transaction. Ireland has seen its first mortgage covered bond, and Barclays Capital would expect issues out of Sweden, Norway and Italy in the near future. The efficiency of covered bonds has also been discovered by countries with a common legal system. Countries such as the UK have successfully issued structured covered bonds, and this success has prompted interest from other similar jurisdictions such as Australia.

The rapid growth has been the result of accelerating institutional investor interest in covered bonds. In general, covered bonds have become increasingly attractive for the traditional government bond investors. Covered bonds provide a higher yield compared to a government bond, have strong credit ratings and a high degree of liquidity due to the market-making agreements of the underwriting banks.

At a time when many finance ministries are running larger budget deficits, covered bond issuers can issue only under strict guidelines and offer a balanced and diversified portfolio risk. As a result, portfolio managers around the globe have included covered bonds in their indices, causing increased purchasing.

There are also specific local reasons driving this growth. In Japan, where yields in yen are low, many investors have been willing to invest in high-quality, liquid, Euro-denominated securities for the extra yield. In Australia, many investors (including mineral exporting companies) have found their liquidity rising on better commodity prices due to strong Asian demand. With the A$ yield differential reducing and the currency expected to weaken this liquidity has helped the demand for covered bonds.

In non-Japan Asia, the higher return of covered bonds can provide central banks with an alternative to government bonds. The movement of central bank money flowing into covered bonds has been strong for the last few years. Many more central banks from diverse regions such as Asia, Middle East, Africa, Eastern and Western Europe and the South Pacific, are now investing reserves in covered bonds. These central banks are also attracted by the tight controls surrounding covered bonds.

Going forward, the market is likely to be supported by an increasing number of countries developing a covered bond instrument. Many local investors, who might not have been involved in the covered bond market previously, are now investing in their local market. Having become comfortable with the instrument, they are making cross border investments into other covered bond instruments. The inaugural UK covered bond opened up a lot of traditional UK-focused investors not only to UK covered bonds, but also covered bonds from other jurisdictions. Many covered bond issuers outside the UK have seen the participation from UK investors in their programme increase.

This trend for covered bond investment is now spreading to the other side of the Atlantic. More issuers of covered bonds have been issuing 144a eligible securities that have been placed with qualified institutional buyers. More covered bond issues are now denominated in US$ compared to a few years ago, and the accountancy issues with the US agency market has freed up liquidity for investment in covered bonds in North America. As some of the issuers have increased their lending activity in the US, this increased investment interest in covered bonds should continue.

Credit ratings understood
With the rapid expansion of the covered bond market, and more covered bonds being sold cross-border, ratings have increasingly become a focus. Historically, the issuer's credit strength was the driver for the rating of the covered bond, with the secured nature and quality of the collateral being reflected by a few notches. Over time, issuers and regulators have invested a lot of time and effort in strengthening the covered bond instruments. This has improved the security position of the investors and has introduced the ability to analyse the risk of the collateral independent of the credit strength of the issuer. The result is that more sophisticated risk assessment tools can be used and the highest ratings can be achieved irrespective of the rating of the issuer.

To achieve the highest credit ratings there are generally four categories of risk that need to be considered.
The first category is the credit strength of the assets. While most covered bond instruments are restricted by the type of assets, the risk within a certain type can vary materially. For example, the loan-to-value restriction for mortgage assets is only one of the determinants of the risk inherent in the mortgage asset. Other factors such as affordability, credit quality of the borrowers and diversification play an important role. For public sector assets the level of creditworthiness will vary by the amount of government support in the system. It also makes a difference in which jurisdictions the assets are located. The assets in the pool in combination with any overcollateralisation for the benefit of the investors should be compliant with the rating level.

The second category of risk deals with market risk. Market risks are introduced when the assets are either paying interest on a different basis, or are paying interest in a different currency. Covered bonds have historically been and still are predominantly fixed rate, while the interest rates on the assets often vary. Public sector assets are often also fixed rate, which creates a manageable mismatch. Mortgage assets across Europe however are predominantly based on a floating rate, with the notable exception of Germany. The mismatch between floating rate on the mortgage assets and fixed rate on the covered bonds will need to be mitigated to obtain the highest rating levels.

The third category is asset-liability management risk (ALM), also called liquidity risk. The risk stems from the different repayment profiles on the assets compared to the covered bonds – while covered bonds are bullet securities, the underlying assets either are bullet but do not mature on the same dates (public sector assets), or are not bullet but follow, for example, an annuity repayment profile (mortgage assets). This risk takes two forms: 1)reinvestment risk, because the principal cash flow received before a repayment of the covered bond is due will need to be reinvested; and 2) refinancing risk, because when a bullet covered bond is due for repayment, there will not be sufficient principal receipts to repay the bullet. Apart from Denmark, where the balance principal matches the term of the bonds with each individual mortgage, all other covered bond jurisdictions are subject to this refinancing risk. The size of the refinancing risk will depend on the liquidity and quality of the assets in the pool, which will determine the ease of monetising the assets.

The fourth risk is the operational risk, which includes, for example, the certainty of segregation of the assets within the legal framework and the certainty there will be a quick resumption of servicing obligation in the event of issuer default.

The mitigation of the four risks outlined above creates a further risk: counterparty risk. A risk is only mitigated as long as the counterparty is able to fulfil its obligations, and thus counterparties are generally highly rated well established financial institutions, but the rating agencies will also insist that substitute counterparties are found if the credit rating deteriorates.

The outlook
The covered bond market has seen a dramatic growth over the last few years and some market observers are asking whether the recent growth is sustainable. As more investors around the world participate in this market and new investors in traditional markets become involved (such as the smaller German savings and cooperative banks) the future looks positive. When one compares the outstanding jumbos of the covered bond market to the size of the European government bond market and US agency market, the growth potential is great.

From the supply side, the number of covered bond jurisdictions is growing, and for the first time has moved across the Atlantic to Mexico. The new frameworks will increasingly be tailored to ensure the highest credit ratings can be achieved, hence focusing on being able to mitigate the risks outlined above, which should have a positive impact on the homogeneity of covered bonds going forward. There will always be differences in collateral to be observed, but these differences can be mitigated in a consistent manner. With the increase in the number of issuers and jurisdictions, the strength of the covered bond globally is beyond doubt.

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