07/16/2010

European Unease Lifts Covered-Bond Sales

Europe's fiscal woes are propelling covered-bond issuance toward record levels.

Funding costs are at the core of the trend. With much of Europe facing prolonged financial and economic troubles, investors are demanding higher yields on traditional home-loan securities and unsecured debt than they are willing to accept on covered mortgage bonds - making covered bonds more appealing for issuers.

Earlier, Societe Generale researcher Jose Sarafana predicted that issuers would distribute €164 billion ($210 billion) of covered bonds worldwide in 2010 - the bulk in Europe. But with year-to-date issuance volume already at €126 billion, that estimate should be easily surpassed. In fact, Sarafana now says he expects the 2010 tally to come in at €180 billion to €190 billion, slightly higher than the €179 billion record set in 2006 and well past the 2009 count of €130 billion. At this point last year, volume was at €47 billion.

While covered-bond activity has been running ahead of expectations for months, Europe's fiscal troubles are adding more thrust. And the projections could climb even higher if the economy or sovereign-debt outlook deteriorates. In the region's latest sign of instability, Moody's downgraded Portugal's sovereign-debt rating two notches to "A1" on July 13.

Why covered bonds? Investors like the fact that the instruments are backed by specific pools of cashflows, which can make them safer than unsecured debt. Meanwhile, traditional mortgage-backed securities still have a black eye from the global credit crisis.

An example of the funding-cost differential: On June 24, Eurohypo priced €500 million of four-year covered bonds with triple-A ratings at 24 bp over swaps. That's 12-14 bp tighter than prevailing spreads for similar issues in April. Mortgage-backed securities have moved in the opposite direction, with senior five-year paper now changing hands on the secondary market at spreads of 145-165 bp - compared to 108-110 bp in April.

Many of this year's deals - €26 billion in all - have totaled less than €1 billion each. Sarafana said that supply wasn't expected, and that a continued flow of such transactions could cause his projections to rise even higher. Another factor in the current issuance tear was a €60 billion program through which the European Central Bank bought both new and old covered-bond paper. While that facility halted its purchases at the end of June, market players credit it with getting deals flowing after last year's dip. U.S. buyers, in particular, seem to have a newfound appetite for the paper.

For now, deal volume has dropped off a bit. Much of the remaining supply is expected to hit the market in the final four months of this year, after bankers and investors in Europe return from their summer breaks. In the meantime, issuers in Canada and Asia are kicking in their share. For instance, CIBC sold $1.25 billion of covered bonds on June 25, while Korea Housing Finance Corp. placed a $500 million deal July 8. Both transactions carry five-year lives and were distributed in the U.S.

Banks in the States remain on the sidelines, as lawmakers struggle to come to grips with a legal framework for such deals.

Covered bonds are secured by revolving pools of assets, typically mortgages, but are also underpinned by the creditworthiness of the issuers. Like traditional securitizations, they can earn triple-A grades even when the issuers carry lower ratings.

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