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European covered bonds - how to find value in today’s market Back  
The launch of Irish covered bonds in 2003 spurred Irish investors to allocate to this asset class, and Ireland is now one of the biggest centres for covered bond investors in Europe. After two years of outperformance of these bonds, and with a host of new countries entering the market including Italy and Norway, spreads versus government bonds and swaps have now reached historically tight levels. So where can investors find value? Ralf Grossman recommends selective bond picking, and participation in selected primary market transactions.
<<<Today, the European covered bond market is the largest non-sovereign high-quality liquid asset class in the Eurozone bond market. With the emergence of the market segments in France, Spain, Ireland, UK, Luxembourg and Austria throughout past years, the covered bond market turned from a German Pfandbrief market into a real pan-European asset class, providing investors with interesting opportunities of diversification.

The year 2005, ten years after German mortgage banks launched the first Jumbo-format covered bond, will be another interesting year for the covered bond market. Investors’ excess liquidity and primary market activity will provide fresh stimulus to the covered bond market and generate numerous new relative value opportunities. The launch of new segments, notably in Italy, Portugal and Norway, and numerous changes and amendments in established covered bond frameworks will broaden the market and increase investors’ confidence.

On the regulatory side, under the new EU Capital Adequacy Directive (CAD 3) the risk-weighting for covered bonds will probably vary much more between different issuers and national regulations.

Tight spreads put focus on primary market transactions
After two years of outperformance of covered bonds, spreads versus government bonds and swaps have now reached historically tight levels. As the current environment of tight spreads is likely to prevail this year, real money accounts (funds or insurance companies) are likely to stay neutral or underweighted in covered bonds, but could not get around covered bonds due to the importance of the segment.

As credit quality considerations are staying at the backburner, credit risk premiums in the covered bond market could be compressed further. Moreover, in the current low-yield environment, investors’ appetite for yields should remain sustained in 2005. Additional demand for covered bonds will be driven by excess liquidity in financial markets. This and the stable credit environment should keep on going the current trend of swap spread narrowing, in particular at longer maturities.

In terms of relative value strategies, investors should focus on selective bond picking. In particular, participation in selected primary market transactions should offer twofold benefit as most new covered bond issues are expected to be launched with slight yield pick-up over the secondary market.

Additional outperformance in secondary market trading could result when small outstanding bond volume creates shortage or tensions.

Market segments with larger spread dispersion, like Spanish C?dulas and German Mortgage Pfandbriefe, offer more bonds with above-average pickup. Segments with small spread dispersion, like French Obligations Fonci?res, are appropriate for defensive positioning and should provide more comfort in a rebound of volatility.

New market segments broaden range for diversification
Italy will be the most important new covered bond market segment to be launched in 2005. Cassa Depositi e Prestiti (CDP), a public owned financial institute, is already in the starting blocks to launch covered bonds backed by claims vis-?-vis Italian central, regional and local authorities. The total volume of CDPs covered bond program will be E20 billion. The expected ratings of the covered bonds are Triple-A from the major three rating agencies.

Moreover, Italy is currently preparing an extension of the well-known Securitisation Act 130/99, which allows securitisation companies to provide guarantees for senior bank bonds. The securitisation company will host the cover assets that will be used to make the payments on the covered bonds in an event of bankruptcy of the issuing bank.

The draft of the Italian covered bond law, which still has to be completed by regulations of the banking supervisory authority, provides the basis for refinancing residential mortgage lending and public sector lending of Italian universal banks. As the entire mortgage loan market in Italy has a volume of around E450 billion, the potential issuance volume of Italian covered bonds is important, which we estimate at E10-20 billion per annum.

Norway and Portugal are probably joining the covered bond market a bit later this year. Belgium is also working on a covered bond law that is largely inspired by the French Obligations Fonci?res framework.
Dutch secured bonds, issued by ABN AMRO Bouwfonds Nederlandse Gemeenten N.V. and Achmea Hypotheekbank N.V., are currently placed at the sidelines of the liquid Euro Jumbo covered bond market. The small number of issuers and issues is also related to the fact that securitisation plays a key role in refinancing mortgage lending in the Netherlands. In the medium-term, under IFRS accounting rules and Basel II/CAD 3 Dutch banks may turn increasingly to the secured/covered bond market.

Regulators in existing market segments are not idle and consequently numerous changes and amendments in established covered bond frameworks will surface in 2005. The most important will be the introduction of a general Pfandbrief law in Germany that replaces the specialist banking principle by a Pfandbrief license. The new Pfandbrief law is unlikely to jeopardise the credit quality of the Pfandbrief. The abolition of the specialist banking principle is to some extent compensated by the requirements of the Pfandbrief license.

Moreover, we believe that the systemic industry support implied by the specialist banking principle has lost its importance as a credit factor during the past years when credit fundamentals of the whole industry weakened and mergers produced large entities. Time will show how German mortgage banks will use the freeing from the activity restrictions of the Mortgage Bank Act. Taking the current senior unsecured ratings into account, mortgage banks have no room at all to allow deterioration of their risk profiles. What is more, it has to be seen which commercial banks will join the group of Pfandbrief issuers, but it is very unlikely to see any ‘exotic’ names.

Regarding the range of potential issuers, we have to differentiate between the domestic Pfandbrief market and the international Jumbo Pfandbrief market.

Whereas a probably large range of smaller new Pfandbrief issuers (mainly savings banks) will target the domestic market with small issuance volumes, only a few new issuers will be able to generate large enough issuance volumes to join the international Jumbo Pfandbrief market. Therefore, we do not expect a significant number of new issuers to arrive at the Jumbo Pfandbrief market in 2005. Nevertheless, we believe that in the medium-term the German legal framework will become flexible enough to allow the German banking sector to develop innovative structures and business models to maintain a significant market share of the international Jumbo covered bond market.

In Spain, several legal amendments came into force in 2004, which will have important repercussions on the C?dulas market in 2005. The new Spanish Insolvency Act reduces the default probability of C?dulas and gives investors more comfort in event of default of the issuing bank.

Moreover, Spanish tax authorities have clarified that Spanish C?dulas will not be subject to the domestic withholding tax for non-EU residents if they prove that they are not residents of a tax haven. This mainly affects Switzerland, Japan, China, the USA and Canada and should create substantial demand for Spanish C?dulas from investors in those countries.

The treatment of covered bonds under the new EU Capital Adequacy Directive
Under current EU bank capital adequacy rules, the treatment of covered bonds is fairly harmonised. Almost all major Euro covered bond market segments, with the famous exception of the UK covered bonds, enjoy the privileged 10 per cent risk-weighting. Accordingly, risk-weighting does not play an important role for covered bond market relative value; again with the exception of the UK covered bonds.

Under the new EU capital adequacy directive, the risk-weighting for covered bonds will probably vary much more between different issuers and national regulations. The main reasons behind this are (i) the existence of different approaches to determine the risk-weights (two standardised approaches and two internal rating based (IRB) approaches) and (ii) the linkage of the covered bond risk-weight to the underlying individual credit quality of the issuer.

Our simulations show that under the IRB foundation approach, due to the current lower average senior unsecured ratings of Pfandbrief issuers, the average risk-weight of German Jumbo Pfandbriefe would be 1.8 times higher than the average risk-weight for French Obligations Fonci?res.

The impact of the risk-weight on the relative value position of a covered bond should be an amplification of the impact of the issuer credit quality, a factor that already plays a significant role in covered bond relative value. Consequently, the new EU capital adequacy regulation will probably widen the relative value spreads between issuers of different credit quality.

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