COMPASS - Barclays Wealth

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Barclays Wealth Global Research & Investments Fadi Zaher, PhD +44 (0)20 3134 8949 fadi.zaher@barclayswealth.com Covered bonds – flight to quality Covered bonds are one of the fastest growing debt instruments, offering investors attractive defensive and yield-enhancing features. In our current ‘muddle through’ scenario for European economies, fiscal retrenchments and improved sentiment towards the financial system should benefit covered bonds. They continue to appeal to a wide range of investors, including short-term cash investors and asset managers as well as long-term investors such as pension funds and insurers. This year the market is expected to continue to grow, beyond its European hub, further supporting the market. History may not repeat itself but it rhymes… Covered bonds are a debt instrument with a secured priority claim on ring-fenced assets. They have become an increasingly attractive investment for both cash-oriented and longterm investors. During tense market episodes, covered bonds tend to remain resilient and outperform other corporate bonds. The majority of them have triple-A ratings and therefore tend to perform in-line with other safe haven assets. Last year was no exception: yields of covered bonds fell by about 80bps, not far behind the fall in developed government bond yields of around 100bps (Figure 1). In our view, this performance was largely driven by the ECB’s covered bond purchase programmes, by concerns about the global economy and the European banking system, and by weaker risk appetite. The investor base is well established in Europe and is gaining ground in other geographies such as Australia, New Zealand and the US. More recently, covered bonds have been considered by investors as a substitute for government bonds, as well as for senior unsecured bank debt, in peripheral Europe against the backdrop of tension in the European wholesale funding market and an economic slowdown in the euro area. Figure 1: Covered bonds spreads and yields over sovereign bonds Yield, % 6 5 4 3 2 1 0 -100 Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12 Global Covered Bond Yields (LHS) Spread Yield of Covered Bonds vs Developed Government Bonds Spread Yield of Senior Financial vs. Covered Bonds Source: Barclays Capital and Barclays Wealth Strategy Spread, bps 400 COMPASS March 2012 6 300 200 100 0
Barclays Wealth Global Research & Investments In recent years, the euro area debt crisis and regulatory changes have driven banks to diversify their sources of funding in major currencies beyond euro-denominated issues. Covered bonds have been one of the main sources of funding for financial institutions globally. Bond issuance reached a record €240bn in 2011, with the total market size now standing at just over €2.5tr (Figure 2). The market is expected to expand by an additional €88bn in 2012 across the major currencies. Although the largest part of the market is likely to remain in euros (c. 80%) some of the expansion is expected to emerge from non-euro area peripheral countries, North America and Asia-pacific. Figure 2: Gross EUR, CAD, CHF, GBP and USD covered bond issuance 1998-2012 (EUR bn equivalent) bn, EUR 250 200 150 100 50 0 105 127 120 COMPASS March 2012 7 95 87 131 128 155 1998 2000 2002 2004 2006 2008 2010 2012e France Germany Netherlands Italy Other Spain Sweden UK Source: Barclays Capital Because of their liquidity, cash and short-maturity investors often consider covered bonds as effective diversification vehicles for their cash deposits and other instruments. With its established investor base, demand for covered bonds remained solid in the core developed world (Germany, France, Nordic countries, Canada and others), despite tensions in the euro area and uncertainties about the economy. …but as safe as houses? A covered bond is a debt instrument that is issued by a bank and is backed by a pool of collateral (mortgages account for 90% of the market, but some include public sector debt or a mix of both). Importantly, that collateral remains on the issuing bank’s balance sheet. Banks hold regulatory capital against the underlying loans, further reducing moral hazard since it’s in the banks’ interest to maintain the high quality of those loans. In the event of default, investors have claims on the ring-fenced asset, making the collateral pool a contingent security. Generally, the collateral sits in a separate Special Purpose Vehicle (SPV) or subsidiary, similar to securitized debt instruments where the SPV is acting as guarantors of underlying collateral, but different in that the SPV is on the bank balance sheet. Another difference with securitised mortgage-backed bonds – the source of much investment trauma in 2007-9 – is that the SPVs associated with securitised mortgages (ABS/RMBS) are completely isolated from the mortgage originator and tend to “slice and dice” or repackage into tranches different risks of the collateral pool when issuing bonds. This is not the case with covered bonds. A covered bond SPV/subsidiary does not itself issue the covered bonds, and is not isolated from the originator. The credit quality of the mortgages is actively managed and audited and has one pool rating (Figure 3). This provides transparency to the content of the cover pool and stricter governance around the content of the collateral. 209 184 106 134 223 245 200
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COMPASS - Barclays Wealth

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