Covered bond investments gain popularity
Bond fund managers are increasingly viewing covered bonds as an alternative to government bonds. Cristina Costa, senior covered bond analyst; Jennifer Levy, covered bond analyst; and Laurence Ribot, head of covered bond and SAS syndication at Natixis explain why, and discusses what managers should know about this asset class
Covered bonds are debt securities typically backed by a pool of mortgages or public sector loans, which is replenished if a loan within the asset pool defaults. Issuance of these bonds – which are an important source of funding for banks – grew significantly in 2005 and 2006, and then again in 2008 when banks’ access to senior unsecured wholesale markets all but dried-up. Now, as ‘bail-in concerns’ (the idea of forcing losses on to senior unsecured debt holders in collapsed banks to ease the bail-out bill to taxpayers) have increased the cost for unsecured funding, the added security provided by covered bonds is being viewed more favourably by creditors, encouraging banks to use this method of funding.
(From left to right: Cristina Costa, Jennifer Levy, Laurence Ribot)
Moreover, new regulation for capital requirements within the Basel III and Capital Requirements Directive IV regulatory requirements have benefited covered bonds over asset backed securities (ABS), the third key funding tool for banks. Indeed, the covered bond structure also provides investors with recourse to both the covering asset pool and the issuer in the event of default, offering a considerably lower risk profile than ABS.
Meanwhile, geographical growth of the covered bond market has been supported by the introduction of a wave of legal frameworks between 2009 and 2011, which have allowed issuances for the first time in jurisdictions such as Australia and New Zealand.
Demand for covered bonds has increased in recent months as returns on benchmark government bonds have dropped to record lows. Naturally, fund managers and other investors are drawn to an asset class that offers higher yields but without significantly more risk, which has encouraged the development of dedicated covered bond funds.
Meanwhile, different types of investor are attracted by different tenors. As you might expect, when the proportion of five and 10 year tenors increased markedly at the start of 2012 the proportion of covered bonds purchased by pension funds and insurers increased significantly, from 12 per cent in 2011 to 22 per cent. Indeed, at the start of 2012 more than 70 per cent of covered bonds issued in Europe were launched with five year tenors or longer – tapping into this appetite.