Government bonds have traditionally proved a favoured investment vehicle for institutional clients during periods of heightened market anxiety. However, looking beyond the boundaries of the government bond market at Pfandbriefe, and their equivalents across the Euro-zone, may prove worthwhile and afford more than adequate credit quality.
Pfandbriefe are first-rate and highly liquid bonds that are available to investors in the Euro-zone market. Because of their long tradition and sizeable market volume, Pfandbriefe, and in particular Jumbo Pfandbriefe, issued by German names are the market segment most interesting to institutional investors. Many issues have outstandings above e3bn, similar to many government bonds; this, coupled with market-making obligations, ensures good liquidity. Jumbo Pfandbriefe, with volume of e3bn or more, are also traded on the EuroCreditMTS platform.
Covered bonds issued by French, Spanish and Luxembourg-based banks are still lagging their German equivalent, but gaining ground rapidly, becoming a focus of investor attention. Debtors in these countries have floated numerous issues in Jumbo format (ie, with a size of at least e500m), making these bonds interesting to institutional investors.
With e1,056bn in outstandings the German Pfandbriefe are the single largest category of such collateralised bonds. The Pfandbriefe has its origins going back 200 years in the then Prussian region of Silesia. The original product has been mimicked many times, to varying degrees of comparable legal and legislative support. All Pfandbriefe style (or covered) bonds share some unique charachteristics; all are issued by bank financial institutions, and are secured by specific assets of pre-defided quality. The German Jumbo Pfandbriefe market, however, is by far the most renowned and mature of the markets for these products. The outstanding volume of Jumbos is currently e375bn in German Jumbo Pfandbriefe, e16.5bn in obligations foncières, e5.5bn in cédulas hipotecarias, and e3.5bn in lettres de gage. Table 1 categorises the 13 jurisdictions in Europe from where these four and the other categories of covered bonds originate.
Of the German Pfandbriefe, over 75% are supported by loans to the German federal or state governments or other institutions of the public sector in Germany or within the EU (Oeffentliche or public sector Pfandbriefe). The balance are supported by mortgage collateral, and are often compared to mortgage backed securities; they are however fundamentally different – the former is a funding instrument, whilst the latter also creates capital and balance sheet efficiencies for originators, employing, usually, an SPV, trustee based structure.
Investments in Pfandbrief-like products offer value, commanding handsome yield premiums over government bonds. This sentiment, boosted by perceptions that government bonds might ‘become extinct’, (often somewhat exaggerated, at least where the Euro-zone market is concerned) caused spreads to widen considerably last year, temporarily reaching levels only seen during market crises in the past. As no banking crisis is expected (especially in the Euro-zone), even if global economic growth decelerates significantly, Pfandbrief-like product are likely to command increasing attention, thanks to their first-rate credit quality, in an environment characterised by low capital market yields. Accordingly, we expect Pfandbrief-like product spreads to tighten further relative to government bonds. Additionally, since Pfandbrief-like products offer higher yields and are affected by interest rate movements following a time lag, they are likely to provide a cushion against a reversal of current interest rate trends. Already in 2001, we have seen the spread differential between Jumbos and Bunds moving in a range of 55 to 65 basis points in the 10-year sector.
Each of the covered bond categories identified in Table 1 is inherently different. Each affords an investor different marginally differing investment returns, reflecting their marginally different risk profiles. The four most significant covered bond categories originate in Germany, France, Luxembourg and Spain, and these are defined in greater detail in Table 2.
The risks and protection afforded are reflected to some degree in the price of the bonds in the market. Other price sensitive factors include liquidity of the bonds and early redemption risks. The primary differences between the four covered bond types highlighted in Table 2 are:
q The specialist nature of the issuer for all bond types except cédulas; thus affording investors protection against risks associated with other commercial banking activities or these other bond types. Cédulas, on the other hand, are exposed to risks associated with the issuer’s other business.
q Statutory protection to creditors in the event of a moratorium on the issuer’s debts in all bond catageories except cédulas, enabling investors to receive continuous debt service in such an event. This emphasises the greater credit ‘linkage’ between a cédulas issue and other covered bonds.
q Cédulas, however, are afforded protection against downgrade risk through standard over-collateralisation which is not required elsewhere.
q Market risk protection for obligations foncières is protected in statute. This is especially important due to current perceptions that certain specalist banks have introduced a high degree of gap risk into their liability management (see below).
The regulations relating to German Jumbo Pfandbriefe and comparable issues out of France, Spain and Luxembourg differ, resulting in spread differential. Cédulas are judged by the market as relatively less secure than their German, French and Luxembourg equivalents, resulting in higher spread requirements. The argument, that the holders of cédulas have a priority claim against all other creditors and that the issues carry a decent over-collateralisation is not accorded sufficient value to offset these concerns: spreads are generally higher.
Against this background, the German Federal Supervisory Office for Banking ruled that, commencing 10 April 2001, all mortgage banks must disclose the amount of their current risk exposure monthly. If a bank’s risk exceeds 10% of its liable equity capital, the banking supervision intends to review the institution’s capacity to bear that risk. If a mortgage bank carries a risk exposure of 20% or more of its liable equity capital, the supervisory body intends to examine whether the institution’s underlying business activities comply with its generally accepted business practices. This reporting will lead to further differentiation between issuers in the market for German Pfandbriefe.
Since last year mortgage banks have focused increasingly on marketing activities and focused on establishing and cementing their credentials with German and particularly international investors. Since most Pfandbriefe carry triple-A ratings, the mortgage banks have taken to flaunting the quality of their cover funds, the liquidity of their issues, their availability in all maturity sectors and membership in EuroCreditMTS to demonstrate their strength relative to their competitors. This emphasises that differentiation between issuers in the Jumbo Pfandbrief market is already well advanced. The regulators’ latest measure (monthly risk reporting) should support this trend. This was endorsed following the recent decision by Moody’s to place Pfandbriefe issued by Allgemeine Hypothekenbank on review for possible downgrade (pending a review of their interest rate exposure and liability management policies), causing these Pfandbriefe to cheapen rapidly.
Iain Barbour is global head of structured finance research and
Peter Mueller and Annegret Hasler are in fixed income research at Commerzbank Securities