The Costs Of Switching Bonds

As Tracy Alloway explained in a feature article earlier this week, covered bonds are attracting investor interest for two reasons: regulators are encouraging banks to issue them by giving covered bonds lower capital charges than unsecured debt under the new Basel III rules; and investors are attracted by the fact that they are collateralised and are (so far) considered as unlikely to share in possible future bank “bail-ins” (loss-sharing).

Not all investors are crazy about covered debt, though. You have to give up some yield to switch from holding unsecured debt to owning debt that’s further up the capital structure of the issuing bank—85 basis points a year in the case of a recent seven year covered bond issue from the UK’s Coventry Building Society, according to a recent news story from Institutional Investor.

Other sceptics point to the fact that the “cover” in the covered bonds may not be as watertight as it sounds. Spanish banks, for example, have been issuing record amounts of covered debt but reveal relatively little about the performance of the mortgages backing the bonds, said one concerned investor.

Also, rules on the extent to which covered bonds push other bank creditors (depositors and holders of senior/subordinate unsecured debt) down the repayment pecking order may vary from one European country to another, Tracy reminds us in her IndexUniverse.eu feature.

Nevertheless, ETF holdings show that an increasing number of investors are making the switch from unsecured to secured debt.

iShares’ Markit iBoxx Euro Corporate Bond fund (LSE: IBCX), for example, Europe’s largest corporate bond ETF, has seen around 20 percent of its assets leave since last September. It tracks an index that has half of its assets in the unsecured debt of European financial companies, so this perhaps reflects increasing concerns that senior bank debt might indeed face future losses.

Meanwhile, iShares’ Markit iBoxx Euro Covered Bond ETF (LSE: ICOV) has seen its assets more than double in the last six months, with inflows accelerating of late.

And you actually get a yield pick-up trading out of IBCX into ICOV, from a redemption yield of 3.25 percent to 3.88 percent, according to the iShares website. If that appears to contradict what I said earlier about covered debt paying lower interest rates than senior unsecured bonds, in this case it’s explained by the index composition. IBCX has around half its assets in non-financial bonds, which currently pay less interest than financial debt, on average, while ICOV has a heavy (28 percent) weighting in covered banks issued by Spanish banks, which are perceived by the market as riskier and have been paying higher rates as a result.

There’s also a significant difference in the ETFs’ trading costs, according to issuer iShares.

For the first four months of 2011, the average time-weighted bid-offer spread on the London Stock Exchange was 12 basis points for IBCX but over double that, 29 basis points, for ICOV.

Remember, also, that recent months have witnessed relatively benign market conditions. In more volatile times, these dealing spreads may well rise. You don’t have to go as far as the alarmism of Dan Fuss, bond fund manager at Boston-based Loomis Sayles, who warned earlier this week in FTFM that ETF investors could face “haircuts” of up to 10 percent in corporate bond funds if they all tried to sell at once, to realise that we’re dealing with a sector of the market more suited for buy-and-hold investing than for trading.

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