10 years of Pfandbrief

Since the launch of the first Jumbo Pfandbrief 10 years ago, the covered bond concept has spread throughout Europe yet many credit investors still avoid the product. Ted Packmohr and Richard Kemmish respond to some commonly held prejudices


German Pfandbriefe date back to the eighteenth century. But time has hardly stood still for the asset class. The Jumbo's success over the past decade is a good example of how the market has managed to reinvent itself over time. Issuers have continuously striven to promote acceptance of the product, particularly among international investors – after all, this was the very reason why the Jumbo was created. As a result, since 1995 several legislative and regulatory amendments have been put in place. Present value coverage and over-collateralisation requirements were introduced, supervision broadened, and there is a new Pfandbrief law to be enacted in July 2005. In addition, various improvements in market and issuing standards have been achieved, such as the introduction of a fixed-price re-offer pricing system, pot structure, raising of minimum volume, guidelines for taps and buybacks. There have also been new product variations such as globals and greenshoe, among others. This innovation as a response to investors' changing needs gives witness to the ongoing modernisation of Pfandbriefe.

This change can also be seen in the terminology. Arguably not as sexy as credit derivatives-speak, which is currently more in vogue, covered bond terminology is slowly but surely being taken over by securitisation standards, with terms such as over-collateralisation and rating triggers becoming more commonly used – another sign of the ongoing modernisation of the market.

Covered bond investors and rating agencies have become more sophisticated and demanding, and product standards are accordingly becoming more rigorous. For example, on the back of an improving bankruptcy remoteness, the bonds' performance will be less driven by the issuer's individual credit than by its pool fundamentals. Hence, all rating agencies have begun to apply a structured rating approach and pool transparency is likely to move to the foreground. An old-fashioned market no more…

A boring investment?

At the risk of being called biased, we maintain you will find it hard to name another European product where more newcomers give evidence of high market dynamics. What started as a German experiment 10 years ago has become a truly European franchise, with liquid Jumbo issuance today coming out of Spain, France, Ireland, the UK, Austria, Luxembourg and Italy, and potential candidates for further 2005 debut issues from countries such as Finland, Sweden and Norway. Over the past 30 months, no less than 17 new international issuers have joined the Jumbo club. That represents a new issuer every two months.

This has helped the market along its growth path, which has now reached the €610 billion mark. To put this into perspective, for the European securitisation market to reach this number, it would need to include all the different rating, currency, liquidity and product tranches. When we speak of the Jumbo covered bond segment, however, we just refer to euro-denominated, large-volume, high-grade paper. Including the non-Jumbo segment leads us to a covered bond volume outstanding of around €1.6 trillion. The market is like an iceberg: what you see is big, what you don't see is enormous.

As a result, we believe that there is a huge amount of trade potential in the covered bond world, offering a broad name and product diversification. In essence, the Jumbo market has become too big and too dynamic to ignore.

The single most important driver behind the creation of the Jumbo was to open up the Pfandbrief product to the international investor base – and it worked. Now, 10 years on, internationalisation characterises the Jumbo market in all its aspects.

On the issuance side, the entry of new countries, as mentioned above, has seen the German share in new Jumbo issuance dwindle to below 40%. At the same time, a larger number of international investment banks have stepped in as lead manager. While the early years of the Jumbo saw its league tables clearly dominated by the big German institutions, competition among lead mangers has heated up and the greater number of issues is distributed far more evenly among a larger number of banks today.

On the placement side, the proportion of German investors in total Jumbo-buying has also declined steadily over recent years to around 35–40%. While selling into the US continues to be low, placement of double-digit percentage numbers in Benelux, Scandinavia and France, some good progress on the Asian front and, in particular, increased acceptance by central banks the world over make the Jumbo a truly international product.

Make no mistake: German investors will continue to play a major role in Jumbo placement and secondary turnover. This is not just because of the considerable investment clout of German investors overall, but also the Pfandbrief's long-standing tradition in Germany and the trust it has established among its domestic client base – a result of the instrument's impeccable track record (no defaults to speak of). Not least, the relatively expensive levels of Bunds make an investment in Pfandbriefe look more attractive to German investors than, for example, is the case for Italian investors evaluating their investment options versus BTPs (Buoni Poliennali del Tesoro, or Italian government bonds).

Added value

As good as all the above may sound, we can still hear credit investors' misgivings: "Covered bonds neither offer the extensive pick-up of real credit products, nor the full security of governments bonds, so where's the added value?"

Of course, covered bonds offer too little pick-up to really play a major role in a dedicated credit portfolio. However, we believe they can add value for the credit investor within inter-market spread strategies.

By assuming exposure in secured products such as Pfandbriefe, investors can maintain a general exposure to banks while reducing their spread volatility. Even some three years ago, when credit woes in the German banking sector also left their mark on the Jumbo segment and led to a significant name differentiation, the performance volatility of Jumbos was naturally reduced in comparison to unsecured debt, as the legislative and structural framework secures a higher creditworthiness. In the meantime, the importance of fundamental credit effects and rating differences for spreads has declined significantly further. According to Dresdner Kleinwort Wasserstein's Jumbo spread model, all things being equal a one-notch rating differential currently translates into a spread difference of around one basis point.

Against this background, Jumbos can keep you in a liquid position while offering protection against credit spread widening, without sacrificing too much pick-up. The recent examples of negative credit news on General Motors and Ford have once again shown that spread movements are by no means a one-way street. While the credit markets were suffering, contagion in the covered bond world was very limited: many Jumbos even managed to display a better spread performance than some BTPs, for example.

As a result, with liquidity being secured through market-making commitments and bid-ask spreads contractually limited, Jumbos could offer alternatives for peripheral governments or agencies in setting up credit spread wideners. Yet another reason to bother with jumbo Pfandbriefe and to join in the celebrations for their first 10 years.

Ted Packmohr and Richard Kemmish are in Dresdner Kleinwort Wasserstein's covered bond team

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