Investment Alternatives in Uncertain Times
For an exception, we are not talking about double-digit returns today, but about yield differences in the second decimal place. What at first glance seems like tedious nitpicking is the daily bread of asset managers who specialize in an area of very safe bonds: Pfandbriefe or covered bonds as they are named.
Covered bonds and why they are so safe
A covered bond is issued by a credit institution. The special thing about this bond, in addition to the issuer's repayment promise, additional collateral is made available to investors. These "cover assets" are held in the so-called "cover pool". Generally, they are mortgage loans or loans to public debtors (municipalities, states, etc.) and the issuance of ship and aircraft mortgage bonds are also possible, but are very rare in reality. In the event of liquidation of the credit institution, the cover pool is separated from the bankruptcy estate and serves to secure the repayment to the covered bond investors.
Mortgage loans or loans to public-sector borrowers are virtually pledged to the holders of the bonds, hence the name "Pfandbrief".
Does the topic bring back negative memories of the 2008 financial crisis for you? Back then a special class of ABS securities (asset backed securities), namely RMBS (residential mortgage backed securities) on so-called subprime mortgages gained sad notoriety. The crucial difference with a covered bond is that in two in which the debtor does not get away from payment so easily. Starting in Europe, you cannot get rid of your mortgage simply by turning the property over to the bank. You remain liable for debts not covered by the pledge, which is usually not the case in the United States. Secondly, the issuer's payment obligation is not exhausted when the cover pool is liquidated. Claims still outstanding thereafter are treated on an equal footing along with other creditors. Therefore, investors have a very high certainty that almost all the capital invested will be redeemed.
Examples for the recovery of collateral? Difficult!
The construction of the Covered Bond is on the one hand so well secured and on the other hand so important to the financial infrastructure that, not even in the course of the GFC (Great Financial Crisis), the realization of assets of the Cover Pool actually had to be relied upon. In the post-GFC world, the "Maximum Conceivable Accident" of a bank is the "bail-in" in the "going concern" case. This means that equity, the supplementary capital, subordinated debt holdings and senior non-preferred bonds have to be written off, but the rest of the bank’s assets in question (including the mortgage business and outstanding covered bonds) is merged with another bank as quickly as possible and with government support. The damage to a jurisdiction (the financial system of the effected country) would simply be too great if the collateralization of the covered bonds did not hold their value. Therefore, the test of bond stability is avoided here at all costs.
What does the investor in covered bonds look at?
As always, the devil is in the details. Despite years of efforts to standardize, each country has its own Pfandbrief law. Until recently, Austria even had three different laws - a real curiosity! Depending on the law, the procedure in case of insolvency is different. Since we do not want to go into every detail of every jurisdiction and additionally of the issuers, here are some examples of what we look for when assessing the attractiveness of a Pfandbrief.
- Creditworthiness of the issuer.
- Country of origin of the issuer and thus the legal regulations that apply to the collateral.
- Collateral in the cover pool: mortgages, public-sector loans, ship loans or aircraft loans.
- In the case of mortgages:
• Does the cover pool consist of residential real estate or commercial real estate? In Austria, a mix of both is common. In many other countries, 100% residential real estate is the norm. Public loans, however, must be kept in a separate cover pool and are only used to secure the corresponding "public covered bonds."
• In which country and region are the properties located, which are serving as collateral? In what condition is the real estate market there?
• What exactly does the cover pool look like? Is it "granular" (meaning many small mortgages, which is better) or are there only a few underlying obligors? How are non-performing loans managed?
• What is the loan-to-value (LTV: amount of the mortgage versus the value of the property)? Typically, a maximum of 80% for residential properties and 60% for commercial properties is required for a mortgage to be included in the collateral pool.
• Does lending occur at a fixed rate or a variable rate? This makes a difference in default risk in the event of interest rate changes.
- Is there a so-called replacement cover pool in place?
- What is the prescribed value of overcollateralization and what is the actual value? Overcollateralization means how much larger is the cover pool compared to the volume of the outstanding Pfandbriefe. By law, a minimum of 2% is customary. Together with the LTV limit, overcollateralization protects the investor in the event of a price decline of the real estate market.
- What is the structure of the issuer? In some countries, a "special bank principle" is common, where the security of the cover pool is completed by transferring the pool to an entity (usually subsidiary of the issuer) that by law cannot go bankrupt. Sometimes (smaller) banks establish a joint subsidiary to issue covered bonds.
You already guessed it: so much security has its price! The yield of covered bonds is significantly lower than that of "normal" bonds. Yet, they offer issuers and investors a win-win situation. The banks can grant favorable mortgage loans thanks to cheap refinancing with covered bonds and for investors, covered bonds are almost as safe as government bonds. Moreover, covered bonds are even considered safer than government bonds. Let us take Italy as an example: It is quite common for Italian covered bonds to yield lower returns than Italian government bonds and, in this sense, to be recognized as safer!
In the event of a bank's insolvency, the cover pool removes many assets from the bankruptcy estate. This can be extremely unpleasant for other creditors as there is not many assets left over for them. Furthermore, even retail customers do not have access to the cover pool and if a default does actually occur, the higher security of some assets is at the expense to other investors.
Why are we writing about this at all?
The difference in yield between covered bonds issued by a particular Austrian, Dutch or French bank is usually less than 0.1% per year. Only professionals have the necessary expertise regarding the legal framework, the issuers and the cover pool to assess the relative attractiveness of these bonds.
Generally speaking, the interest rate hikes by the European Central Bank have made Euro covered bonds so much more attractive. In addition, the premium on German or Austrian government bonds is relatively high. Specifically, Pfandbriefe with 3 to 5 years to maturity currently offer a yield of between 2.5% and 3%. That is 0.5 to 1% more than the German government bond and all this in an environment of major economic challenges - at a time when the creditworthiness of many issuers is being put to the test. In addition, banks will have to return to the market for some of their funding previously provided by the ECB.
We therefore expect a large supply of covered bonds - a clear advantage for buyers. For us, there are good reasons to buy covered bonds at present. We will incrementally increase the share of covered bonds in the bond portfolios we manage.
This was a brief insight into a very special investment opportunity. We hope to have aroused your interest in Pfandbriefe.