Covered bonds, once the driest corner of the European capital market, have survived the credit crunch to become one of the sexiest assets during Europe’s debt crisis.
Now the funding method du jour for Europe’s troubled banks, the bonds are also beloved by European regulators, even as they debate forcing losses on to financial debt investors as a way of lessening the bill to taxpayers for bank bail-outs. But record issuance is pushing the covered bond asset class towards its limits, placing question marks over banks’ capital structures and regulators’ love affair with the debt.
“Governments recognise that the covered bond market and the securitisation market are fundamental funding tools for banks going forward,” says Christopher Walsh, a partner and capital market specialist at law firm Clifford Chance. “To date that has given covered bonds a sort of ‘special nation status’ with legislators.”
So far in 2011, European banks have issued US$185 billion of covered bonds—almost surpassing the US$198 billion issuance of so-called ”senior unsecured” debt.
Though the majority of covered bond ETFs available to investors currently track the debt issued by German banks—or “Pfandbriefe”—some, such as iShares’ Markit iBoxx Euro Covered Bond ETF and Lyxor’s EuroMTS Covered Bond Aggregate ETF, are more heavily exposed to covered bonds in European hotspots such as Spain and Ireland. Overall, though, covered bond ETFs have yet to attract the same scale of inflows as funds offering exposure to conventional, unsecured corporate debt, which have been one of the most popular types of ETF since early 2009.
With origins in 18th century Prussia, covered bonds are a form of secured debt, sitting at the top of a bank’s capital structure and backed by a ring-fenced pool of assets held on the bank’s balance sheet. Issuing banks are legally obligated to replace the assets in the bonds’ cover pools, usually mortgages or public sector loans, if they sour or are repaid early. This means the bonds can require a continuous stream of high-quality collateral and refinancing—an appealing prospect for many fixed income investors.
In the event of a bank failure, if there is not enough collateral within the covered bond to satisfy creditors’ claims, then investors will also hold a senior claim over the insolvent bank’s estate in the event of a bankruptcy. This is the so-called “dual recourse” nature of the bonds, and it is this double safety net, combined with a yield pick-up over other highly-rated bonds such as government debt, that has helped boost recent interest in covered bonds in the midst of Europe’s debt crisis.
As European regulators continue to move towards burden-sharing for the holders of subordinate and even senior unsecured debt in failed banks, investors are increasingly eyeing the bonds as a safer alternative, especially for banks in “riskier” countries. But analysts’ opinions differ as to whether the collateral backing the bonds means they would be unaffected in a broader debt crisis which involved widespread write-downs of bank bonds’ nominal values.
“The safeguards for covered bond holders have been designed to withstand the failure of individual banks, but not to withstand a sovereign debt crisis or a systemic banking crisis,” Barclays Capital analysts Fritz Engelhard and Michaela Seimen told their clients late last month. “The costs of supporting domestic banks have been one of the main reasons for fiscal stress; thus, it would be difficult politically for a government not to let holders of bank debt, including covered bond holders, participate in the burden-sharing.”
“Is there a chance that covered bonds might be affected by the bail-in issues at some point in time? The general answer would be no,” counters Christoph Anhamm, head of covered bond origination at Royal Bank of Scotland. “Covered bonds do not participate in the normal bankruptcy procedure of an insolvent bank, and at the moment, regulators seem to be very clearly excluding covered bonds from the bail-in procedure.”
However, covered bond analysts say there has never been a modern-day default of a covered bond-issuing bank, which means the bankruptcy procedure for covered bonds has never been formally tested. Complicating matters now are the series of resolution regimes that have cropped up post-financial crisis in countries including Germany and Denmark. These regimes govern the winding-up of failed banks, and can involve haircuts for senior debt investors, but many are also untried.