Saturday, February 13, 2010

Covered bond bailouts

Last week FT Alphaville mused on whether covered bonds — darlings of the European debt universe — could make it through a sovereign crisis unscathed.

Here’s a quick Friday follow-up.

From Deutsche Bank’s excellent fixed income team:

Covered bonds trading though sovereign bonds are typically a sell . . . With the recent tightening of Italian sovereign bonds, this has changed and confirms our view that covered bonds trading though sovereign credit, despite potentially having a higher rating, is typically unsustainable, particularly in the primary market. Given the ongoing pressure on public sector credit quality which is likely to worsen further, this point (i.e. the question if covered bonds can trade through sovereigns) is likely to be an ongoing topic. Moody’s mentioned in its 2010 outlook that the ongoing worsening sovereign credit quality is a burden for covered bond ratings.

You can see some of the sovereign stress in the below chart, showing spreads for European countries’ covered bonds. While Italian and British covereds have tightened somewhat in recent weeks, Spanish cedulas, Irish covered bonds, and those of `other’ countries are widening:

What of German pfandbriefe — the safest of the `safe’ bonds? They’ve been flatlining so far, but could eurozone sovereign stress begin feeding into the Deutsche market as well?

Deutsche Bank (perhaps unsurprisingly) thinks not:

The current outstanding volume of German Pfandbriefe amounts to around EUR 720 bn and hence is more than twice the size of Cédulas (which rank second and amount to around EUR 352 bn in total). Hence, the German government has a very strong interest to support Pfandbriefe if the need arise (arguably stronger than the need to support Greek government bonds).

Bundesbank seems to continue supporting Pfandbriefe and seems to have . . . the most ammunition regarding the ECB buying scheme. The interest of the German government in the German market can also be seen in the high covered bond exposure of German insurance companies. The exposure of German insurance companies amounts to around 35% of their assets under management, which are very likely predominantly Pfandbriefe.

Overall, while being short Pfandbriefe versus peripheral covered bonds looks attractive, given the mentioned supportive facts, the performance potential is likely far less that indicated by historical spread charts.

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