Relative merits of covered bonds versus RMBS discussed

Interest in covered bonds continues to grow, partly due to favourable regulatory treatment. However, panellists at a recent covered bond seminar hosted by S&P highlighted the potential dangers of over-promoting the instruments at the expense of other asset classes, such as RMBS.

Neil Calder, head of investments - credit, treasury at the EBRD, noted during the seminar that RMBS transactions have 'hard-wired' or in-built mechanisms that offer protection for investors if things don't go quite as expected. "Recent legislative developments in covered bonds have increasingly emphasised almost 'RMBS-lite' structural enhancements - such as asset-coverage tests, eligibility criteria and limits on loan-to-value ratios. Still, if the originating bank fails, it's questionable if covered bonds would have as much protection as some RMBS transactions," he said.

Gareth Davies, head of European ABS & covered bond research at JPMorgan, agreed that what happens when a covered bond originator defaults is less clear-cut than in securitisations. "In many respects, covered bonds resemble securitisations in 2007, where the market didn't think anything was going to go wrong, despite that fact that they had never been tested," he explained. "So, while covered bonds are a well-established product with over 200 years of history, that's not what credit investors should be focusing on. We should ask: what happens in a tail event?"

The choice between RMBS and covered bonds depends on the jurisdiction, Davies continued. "In Ireland, I would rather own a covered bond than RMBS. However, in the UK it would depend on the collateral quality and the likely degree of regulatory intervention. It comes back to the frequent argument over whether covered bonds are a credit product or a rates product."

The general perception of covered bonds is that they are safe and non-complex investments. "As credit investors, we would probably argue that this is not quite the right perception to have," Calder said. "But there is this sense of familiarity with covered bonds that naturally makes them a more liquid product than RMBS. Additionally, the proposed changes to bank and insurance regulation over the past few years have favoured covered bonds and new jurisdictions have been coming online."

TwentyFour Asset Management partner Rob Ford observed that many covered bonds are now trading wider than triple-A RMBS tranches. "I would generally prefer to buy RMBS over covered bonds. But if I can now buy a covered bond 50bp-75bp cheaper than a triple-A rated RMBS from the same institution, then maybe I will look at covered bonds as an alternative."

He added that if an investor can swap fixed into floating and there is a compelling difference in the relative value between the same types of assets from the same institutions - between a covered bond and an RMBS - then that may be enough for them to consider both instruments.

Davies said that both covered bonds and RMBS have advantages, and suggested that a more varied approach to bank funding should be considered. "If there was a disruption in the covered bond market and we lost access to that particular investor group, then Europe's banks would lose funding without the ECB's support. We may be over-promoting covered bonds to the detriment of the European banking system," he warned.

Although Ford believes there is a valid argument for giving regulatory support to securities that are structurally simple, like covered bonds, he noted that some ABS have stronger support mechanisms than covered bonds. "I don't believe that one consideration should balance the other out exactly, but I think the difference in treatment between the two in some of the current regulatory proposals is so enormous that it doesn't make sense."

Meanwhile, whether single-A will become the new triple-A depends on how the market perceives spread and cost. Ford said that if spreads remain close to where they've been for the last two or three years, the price of issuing senior notes at double-A is too high. If spreads fall over time, then potentially the market could start to sustain lower-rated senior securities.

Further, if the market evolved to a stage where sovereign ratings across major countries were generally at double-A (see also SCI 7 February), then acceptance of double-A ratings on covered bonds and senior RMBS would be seen as much more tenable.