German Pfandbriefe have never defaulted in their more than 230-year existence*, a pretty amazing feat given the turbulent times Germany and the rest of Europe experienced over that era. It has long been this ‘safety’ aspect of Pfandbriefe which has been one of the most attractive features for investors.
“We use Pfandbriefe, or covered bonds to be more correct, in our liquid portfolios,” says Harald Eggerstedt of Cominvest Asset Management. “Covered bonds tend to have AAA or AA credit ratings and a very low default probability. They actually offer slightly higher yields, because although they might have a similar rating to a government bond they are not sovereign-backed. But from an investor perspective, legislation behind covered bonds makes them almost as secure, and so it makes sense for us to get the yield pick-up, however minimal it is.”
Gregor Huetter at Vienna-based CapitalInvest often uses covered bonds as a substitute for governments. He says: “They have perhaps a few ticks less liquidity than governments (bonds), but then we do not have huge turnover in our portfolios. Covered bonds often have better ratings and frequently have lower coupons, which may be more beneficial in terms of taxation treatment. Although it is true that analysing these securities is more labour intensive than looking at sovereigns, once you’ve done it a few times.”
Most covered bond investors’ talk usually focuses on jumbos, securities with an issue size of at least €1bn and market-making agreements (for the maintenance of liquidity). Jumbo Pfandbriefe were first issued back in 1995.
“The beauty of issuing jumbos for real estate lending was that the German issuer could get access to investors all over Europe. For some jumbos as many as half the investors might be non-domestic,” points out Eggerstedt. For the smaller issues, liquidity is significantly lower. CapitalInvest’s Huetter says smaller issues are often appropriate securities for certain of CapitalInvest’s domestic portfolios where trading is not a high priority, but security and quality are.
The last few years have seen an upsurge of growth in the covered bond market in many countries other than the ‘traditional’ ones of Germany, Austria or Switzerland. The introduction of the euro marked the beginning of this change, as interest rates converged downwards and real estate funding became significantly cheaper.
Luxembourg introduced its covered bond legislation in 1997, while the following year Germany reformed its Mortgage Banking Act, and France revised its law on ‘obligations foncieres’ in 1999. In 2001 the first Spanish cedula hipotecaria was issued. Such has been the growth of the cedulas that within four years its share of the euro covered bond market has risen from nil to 17%, making it the second largest sector in the universe.
“Over the last five years we have seen specific covered bond regulations introduced in a number of countries such as France, Luxembourg and Spain,” says Eggerstedt. “With the advent of the single currency, the environment is much more stable for many countries. Spanish covered bonds, or cedulas, have been a very important factor in this rapid expansion and there has been enormous issuance here. As interest rates converged and fell, there has been very rapid growth in real estate lending, not just in Spain but also Ireland, the Netherlands and others. And to raise the funding, cedulas have grown fast, though I do not believe that we are witnessing some sort of a bubble, as home ownership is still very low.”
Bank of Ireland Asset Management is a relatively new investor in covered bonds, but now has significant exposure. Its associate director, fixed income, Audrey Behan states: “Covered bonds are an important asset class within our European investment grade portfolios. We use them as part of our credit strategies, like structured credit products. We like the fact that we can optimise our curve view with covered bonds which, unlike asset backed securities - which are frequently floating rate notes - offer deep liquidity across the curve.
“Another appeal for investors in covered bonds is the increasing diversity of issuers now available. The advent of the single currency and ongoing changes in legislature has enabled many investors to put assets across borders and into other countries’ markets,” she says.
There is no pan-European covered bond legislation. However, most covered bonds share common features. They are distinguished from other assets on the balance sheet of the issuer; the outstanding amount and interest claims on them must be covered by the amount of eligible cover assets; and covered bonds are full recourse debt instruments secured against a pool of mortgage assets or public sector loans.
Although the cover pool is effectively bankruptcy-remote from the issuing entity, as covered bond investors have priority claim on the cover pool, some caution is still advised. “In a normal securitisation deal the assets are removed from the balance and put into some form of special purpose vehicle and thus the bankruptcy link to the issuing bank is severed. However, with a covered bond you must carry out your due diligence and be comfortable with the issuing bank,” says Behan.
Cominvest’s Eggerstedt agrees, adding: “Although the legislation does protect investors with such clauses as over-collateralisation and the nature of the bond holder’s priority claim in the event of insolvency, the issue of pool management is still key for us. We do rely on the rating agencies to tell us about the covered pool, as it is not possible for us to look at each one. We do need to know who is behind the running of these pools and to ensure that everything is being well managed.”
Reflecting the changing issuing patterns, the covered bond indices have changed dramatically too. “In the late 1990s our covered bond indices were composed almost entirely of German Pfandbriefe, while today the mix is much more balanced. We have two indices, one set up by Commerzbank in the 1990s and now managed by the FTSE and the other is the iBoxx Euro Covered index. These two indices are actually remarkably similar as they were both set up wisely avoiding detailed descriptions and rules, reflecting the flexibility of investor preferences and attitudes,” Eggerstedt says.
*The Association of German Mortgage Banks (VDH).
Reference: UBS Investment Research, European Covered Bonds, 13 October 2004. Regina Koelsch.