Dealers draw up contract for covered bond CDSs

Credit Suisse, Deutsche Bank and JP Morgan expect demand for spread volatility protection on covered bonds

Covered bonds could get their own credit default swap (CDS) market, if a new template drawn up by Credit Suisse, Deutsche Bank and JP Morgan takes off. Although the bonds rarely default, the three dealers have been quietly working on the project for almost a year, and expect demand to come from investors seeking to hedge spread volatility on what is a rapidly growing portion of the bank debt market.

"To promote liquidity, we wanted to agree a standardised form of contract. We didn't want to draw up a bespoke agreement each time. With changing regulation, it seems like a natural progression," says Antoine Cornut, head of flow credit trading for the Americas and Europe at Deutsche Bank in London.

The dealers had to confront a number of challenges to make the contract fit the covered bond market – chiefly, defining the appropriate trigger event and reference entity – and although the new confirmation would be appended to International Swaps and Derivatives Association documentation, Isda was not involved in the effort. The three dealers argue it would have taken too long if a broader working group had been involved.

"Between the three of us, we have a good share of the market, and we could put it together quicker than in a larger group. We hope this will become the market standard if it develops," says Cornut.

Should the banks' document result in a more liquid market, covered bond contracts would be expected to trade at around 60%–70% of an issuer's CDS spread for unsecured bonds, according to one trader.

To promote liquidity we wanted to agree a standardised form of contract... With changing regulation, it seems like a natural progression

Covered bonds are backed by a dynamically managed pool of loans, such as mortgages, that remain ring-fenced on the balance sheet of the issuer – unlike typical securitisations – and are typically over-collateralised, often by law. As such, losses are rare – there has not been a default in the German mortgage-backed Pfandbrief market in more than 100 years.

Despite this, the dealers believe the market's recent growth – with the prospect of more to come – will result in demand for hedges against credit spread widening, especially in markets expected to have higher spreads, such as Spain, Portugal and the UK. There is also likely to be interest from more speculative money, such as hedge funds, they say.

In 2011, global covered bond issuance was a record $405.1 billion, in comparison with the previous peak of $361.5 billion in 2010, according to data provider Dealogic. The first quarter of 2012 has seen $153.3 billion in issuance. In part, the covered bond boom is a response to the increased cost of unsecured financing – senior unsecured debt issuance dropped from $1.3 trillion in 2009 to $906 billion in 2011 – and many expect the trend to continue.

Dealers say a small number of covered bond CDSs have traded in recent years – with each trade having to be separately negotiated. The standard document is an attempt to avoid the disputes involved in those trades.

The main hurdle was defining a trigger event – the dealers debated whether the issuer would be required to default on its unsecured debt before a covered bond default could be recognised, for example. Another point of contention was what would happen to the contracts under so-called succession events, in which the legal entity issuing the bonds is split, leaving the reference entity for the contract unclear. The solution was to have the contracts triggered purely by a failure to make a payment of coupon or principal on a bond, and for the contract to reference a specific bond, rather than a legal entity.

There are still some details to be finalised. The recovery rate assumed in the contract, for example, which is likely to be set somewhere between 60% and 80% – higher than the 40% typically assumed for standard CDSs. Dealers are also hoping to encourage liquidity by drawing up an approved list of issuers - although market-makers will be free to quote on all covered bonds. That list is still being drawn up, with at least 16 names currently under consideration, including Barclays, BBVA, BNP Paribas, Credit Agricole, Royal Bank of Scotland, Santander and UniCredit.

One covered bond investor says the idea has some appeal: "It's not something I've thought of getting into, but we could consider it. It may work as a partial spread hedge," says one European fund manager with significant covered bond holdings.

But others worry the advent of covered bond CDSs may affect the market for the cash underlying. "I haven't been hearing complaints from investors about the lack of CDS hedging for covered bonds. Covered bonds have been around for over 200 years without CDSs, and their default record is extremely good. There is a strong possibility it will serve investors with technical or proprietary trading objectives more than institutional real money," says Georg Grodzki, head of credit research at Legal & General Investment Management, the asset management arm of the UK insurer, which has investments in several peripheral European covered bond markets.

"It's not a given that CDSs will help. CDS markets can be illiquid too, especially in their infancy, and mislead rather than lead. The worst thing that could happen would be these contracts mainly being used for bets on rating and sovereign sentiment changes, causing mark-to-market noise and profit-and-loss volatility without any connection to underlying default risks," he adds.

Covered bond protection is the second new form of CDS product banks have attempted to launch in recent months, after dealers agreed standard documentation for contingent credit default swap trades linked to indexes in February.