FOCUS: ECB's Covered Bond Boost Moves Beyond Core Markets

The European Central Bank’s EUR60 billion program of purchasing covered bonds to stimulate the economy has the traditional markets for the bonds, but it is also helping spark issuance in countries where the bonds were previously unknown and in other markets that are among the most affected by the global downturn.

Covered bonds are highly rated bonds issued by banks to refinance residential mortgages or public-sector loans that remain on the lender’s balance sheet. Banks have to maintain the credit quality of the pool of loans, sometimes in accordance with specific legislation, and investors have a claim both on the bank that issued the bond and the assets underlying it.

Because Europe's biggest markets for the securities were Germany and France, there were concerns when the ECB program was unveiled in May that the plan would automatically favor banks in those countries. But a series of recent deals should put such fears to rest.

In fact, the ECB's purchase of bonds from those bigger markets has helped facilitate the issuance of new covered bonds elsewhere in the euro zone, even in one of the countries that has suffered the most.

Ireland’s banking and housing sectors have been hit particularly hard by the crisis, so rebuilding investor appetite for Irish covered bonds was seen as a tough task.

Nevertheless, Bank of Ireland Mortgage Bank, part of Bank of Ireland Group (IRE) , sold a EUR1.5 billion, 4.625% covered bond last week – the first Irish deal since June 2007. It attracted EUR3.8 billion of orders in 90 minutes.

Some market watchers had assumed that central bank participation would be key to reopening the Irish market, with central banks buying a large quantity of bonds directly in the primary market to encourage other investors to participate.

In fact, their role was more indirect, with central banks from the euro zone and elsewhere buying just 11% of Wednesday’s deal.

"The central bank component of the order book was relatively small, and we attracted EUR3.8 billion of orders, so the success of the deal clearly wasn't dependent on central bank involvement," said Jeremy Walsh, syndicate banker at Royal Bank of Scotland, one of the lead managers on the transaction.

"But this is precisely the kind of transaction that the ECB program was designed to help, albeit in a way that is hard to quantify," he said. "Their buying helped spreads tighten to the point where an Irish deal was feasible again, and their implied support of the covered-bond product has also boosted investor interest."

Attractive Yields

Investors are also searching for bonds that offer decent yields. Spreads, or the premium that a bond pays investors versus a benchmark rate, have compressed dramatically since the ECB started buying, in some cases to pre-crisis levels.

Spreads on German covered bonds, or Pfandbriefe, are now around 10 basis points or less over the mid-swaps rate.

The Bank of Ireland deal, by contrast, priced at 190 basis points over mid-swaps, so investors get a much higher return.

One banker not involved on the deal even suggested that the spread was too high, considering that the bonds are rated triple-A and that Ireland's covered bond law affords investors a high degree of protection.

But while the deal pays investors more than they would receive for buying, for example, Pfandbriefe, there are other pricing points to consider.

"Recent one-year government-guaranteed Irish bank debt issues have priced at 160 basis points over mid-swaps," said RBS's Walsh. "To price the first unguaranteed Irish bank debt in any format for nearly two years in a five-year maturity at 190 basis points is an excellent achievement."

The difference in spreads between covered bonds from different markets is striking. In a note published Thursday, Barclays Capital said that covered-bond markets “have reacted asymmetrically” to the ECB purchase program, and recommended investors switch into “markets which are commonly perceived to be weaker than their peers” including the Irish market.

Other issuers are also taking advantage. Monday, National Bank of Greece S.A. (NBG) announced its inaugural covered bond, in what will be the first deal out of Greece to be sold publicly to investors.

And last week, Italy’s Ubi Banca (UBI.MI) announced its inaugural covered bond – one of a handful of new deals to emerge from the country since the ECB’s program was announced.

Both countries have introduced laws on covered bonds, although the market didn't have time to grow before the financial crisis struck.

But investor appetite should be good for these new deals, because central banks are on hand to support prices if necessary.

The Banca d'Italia, for example, has EUR9.9 billion to spend under the program, far more than the total outstanding volume of Italian covered bonds.

That buying power creates a natural issuing opportunity for Italian banks. Even if the central bank doesn't buy bonds direct from issuers, it has considerable firepower to deploy subsequently, when bonds trade in the secondary market.

This gives other investors comfort that prices of covered bonds won't drop after the bonds are issued, and encourage them to invest.

-By Mark Brown, Dow Jones Newswires; + 44 (0)207 842 9485, [e-mail]