| Covered Bonds 101 |
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| 05/12/2004 | |
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Hélène Heberlein, Senior analyst at Fitch Ratings, and Xavier Baraton, Global head of credit research at HSBC Asset Management Europe, answer this week's 101 on covered bonds. 1-What is a covered bond and what are the main differences between covered bonds issued in Germany, France, UK and Spain? (Hélène Heberlein) A covered bond is a debt instrument issued by a financial institution and secured on a portfolio of specific assets, which can be either mortgage loans (both for residential or commercial purposes) or loans granted to/bonds issued by public sector entities. A more precise definition can be found in the draft European Capital Requirement Directive, which foresees favourable treatment of covered bonds for capital adequacy purposes, provided, among others, that the covered bonds are issued under a specific legal framework, and are subject to the supervision of the banking authority. Due to their privilege position in bankruptcy, covered bonds achieve ratings at least equal to the unsecured rating of the issuer, and in most cases much higher than the latter. As such, covered bonds prove to be a cheap source of funding for issuers. Germany's Pfandbriefe Pfandbriefe can currently be issued by selected German financial institutions. The specialised bank principle will be abandoned in July 2005. The German legislation emphasises the conservative valuation of property for mortgage loans in order to assess the maximum eligible loan-to-value (LTV) portion (60%). Also, it creates the figure of a special administrator, different from the insolvency administrator, to take care of the cover pool and the covered bonds upon an insolvency of the issuer, thereby minimising potential conflict of interests. Finally, an overcollateralisation (the ratio of cover assets to outstanding bonds) of at least 2% on a net present value basis is mandatory, including the effect of interest rate and foreign exchange rates stresses. France's Obligations foncières Obligations Foncières (OF), the French form of covered bonds, are issued by specialised financial institutions, the Sociétés de Crédit Foncier (SCF), which are bankruptcy remote from their parent company, insofar as the insolvency of the parent group cannot be extended to the SCF. Furthermore, SCF have to sub-contract all of its origination and servicing tasks, so that they have no employees. The legislation does not foresee separate cover pools depending on the type of assets, so that OF may be backed by mixed collateral. On mortgage loans, maximum LTV ranges from 60% to 100%. Also, a SCF may invest in securitisation transactions backed by eligible assets. As far as overcollateralisation is concerned, the French legislation only stipulates that the nominal value of all assets must be higher than the nominal value of the OF. Spain's Cédulas Spanish covered bonds, called Cédulas, can be issued by any bank, and enjoy the highest mandatory overcollateralisation: 11% for those backed by mortgages with maximum LTV of 70% or 80% (Cédulas Hipotecarias), and 43% for those backed by public sector assets (Cédulas Territoriales). Assets are not recorded on a register, but should an issue be declared insolvent, incoming cash flows from the whole portfolio of mortgage loans (even the non qualifying ones) would be allocated to the mortgage Cédulas holders. However, due to the lack of liquid assets within the portfolio, the timeliness of payment owed on Cédulas may be jeopardised in such a situation. Therefore, Cédulas are the only form of covered bonds among the four countries analysed here to which Fitch assigns a rating closely correlated to the unsecured rating of the issuer. United Kingdom The United Kingdom has no specific covered bonds legislation, but three issuers have so far entered into contractual obligations enabling them to issue covered bonds guaranteed by special purpose companies to which the originators have transferred mortgage loans. Maximum LTV range from 60% to 75% and minimum overcollateralisation from 7.5% to 10%. 2- Why should an institution invest in covered bonds? How much of its portfolio should be allocated to this asset class? (Xavier Baraton) There are three main reasons commanding an investment in covered bonds. The quality of credit usually comes first since most of these bonds are rated triple- or double-A. Second, even with an equal rating, these bonds usually offer a yield about 20 basis points higher than sovereign bonds, and sometimes even more than the yield of bonds issued by peripheral states. Third, these bonds are highly liquid, even for large-sized orders. Large amounts are exchanged daily on the markets, which makes possible for an institution to manage covered bonds much the same way it would manage sovereign ones. Many benchmarks are worth over €1 bn, and it is not unusual to have some benchmarks as large as €3bn to €5bn. There is as well as a liquidity obligation of market making for banks issuing this type of paper. Given these characteristics, traditional buyers of covered bonds are often Buy & Hold investors such as pension funds and life insurers, attracted by the high credit quality of those bonds, as well as large international investors such as central banks, which need to build up reserves that can be sold quickly. Traditional investors such as asset managers are also quite active on this market, for various reasons such as the return offered by those bonds, cash and carry activities, or arbitrage operations against sovereign bonds. It is also necessary to invest in these bonds for replicating a fixed-income index since covered bonds account for 15% of a universe going from sovereign bonds to investment grade corporate bonds 3- What are the main shortcomings of this asset class? (Xavier Baraton) There are two related main shortcomings. The first one is that there are lots of issuers and different types of structuring that mostly depend on the place of issuance. This creates the need for more credit analysis so as to detail the juridical framework and the quality of the underlying bond issuers, which vary from one country to the other. In turn, the quality of covered bonds is not the same throughout Europe, which is reflected in the various degrees of bankruptcy remoteness. For instance, investors in German Pfandbriefe or French obligations foncières are usually more protected than investors in Spanish cédulas. It is also necessary to gather information about the credit risk of the issuer, since what happens to the issuing bank has an impact on the covered bond, even if it is better rated than the bank itself. National regulations are currently changing – positively from an institutional investor's perspective. Every time a new covered bond scheme is implemented in Europe, it tends to use the best elements in existing schemes. This puts pressure on older schemes, that have then to be improved so has to remain competitive. In turn, these changes affect the quality and spread between various issuers. |
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Articles of the same Serie : 101 |
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