Covered bonds constitute a distinct fixed income category that has evolved over the last decade from being a European specialty to a global asset class. First created in Germany to give investors a dual recourse to payment, they allow claims on both the issuer and the assets in the bonds’ collateral pool. So, the bonds are by definition dually “covered” in terms of default risk, and are therefore often sought as a high quality alternative to traditional European government bonds and senior unsecured bank debt. In the past year, covered bonds have seen increased structural demand driven by new regulatory regimes under Basel III and Solvency II.
In the following interview, Kristion Mierau, head of European covered bond portfolio management at PIMCO, explores the potential benefits of an allocation to this unique fixed income category. He also highlights PIMCO’s expertise in the space, and the ease of accessing actively managed exposure to a diversified European portfolio through PIMCO’s Covered Bond ETF.
Q: What are the key characteristics of covered bonds?
Mierau: Arguably the most important characteristic of covered bonds is their “dual recourse” feature. Not only do they have the relative security of being senior bonds issued by financial institutions, but they are also backed by a dedicated and “ring-fenced” bankruptcy-remote pool of collateral (the pool usually consists of mortgages and public sector loans). As a result, covered bonds are uniquely structured to withstand an event of default by issuers. First, the assets in the collateral pool are used to meet obligations. Second, investors have a claim on the issuer itself for any residual losses, because covered bonds are unconditional obligations of the issuing financial institutions and are ranked pari passu to senior secured bonds.
The dual-recourse feature inherent in most covered bonds renders them particularly attractive for those looking for a “safe” asset allocation. In effect, covered bonds sit at the very top of the capital structure, above large uninsured depositors and senior secured bonds.
Q: What is the history and current size of the covered bond market?
Mierau: Covered bonds are the second-largest private debt market in Europe, after senior unsecured bank debt. They were first recorded in Germany over 200 years ago before spreading across Europe, then to North America, Asia-Pacific, and most recently to Mexico and South America, where banks have issued covered bonds or drafted legislative frameworks for their issuance. The total value of benchmark-eligible covered bonds outstanding globally is now close to €1.1 trillion, according to Barclays. The market is well diversified and liquid, comprising in excess of 150 different benchmark-eligible issuers. Remarkably, there has never been a recorded default since the advent of the asset class.
Q: Who are the typical investors in covered bonds, and how do they invest in them?
Mierau: Several different types of market participants invest in the asset class due to the favourable risk/return profile. Historically, covered bonds have offered higher returns and lower volatility than European government bonds, and typically with lower duration or interest rate risk. Many investors, institutional and retail, use them as a substitute for European government bond allocations or correlated higher-beta risk assets, aiming to improve the efficient frontier of their overall portfolio. Given the current level of yields and the negligible probability of principal impairment, in some instances, covered bonds are also a compelling substitute for lower-rated senior unsecured bonds.
Covered bonds may be particularly attractive for bank and insurance companies due to their favourable treatment under various regulatory regimes. For banks, covered bonds have lower risk-weighting under Basel III and are considered as “high quality liquid assets” under its Liquidity Coverage Ratio (LCR). For insurance companies, covered bonds have preferential treatment under Solvency II and offer attractive yield potential without incurring high capital charges.
While some institutional investors invest in covered bonds directly, we think given the diversity of the asset class, most investors would benefit from professional management, either through actively managed separate accounts or commingled funds. Investors seeking portfolio transparency or intra-day liquidity, or who seek to meet regulatory requirements, may also invest in covered bonds through exchange-traded funds (ETFs).
Q: Why should investors consider an active approach to covered bonds when this asset class has never experienced a default?
Mierau: Investors may underestimate the complexity of the asset class and the related benefits of an active approach. Because default risk appears so remote, many investors assume the asset class is homogenous, or they may exhibit a “home bias,” unaware of the diverse set of global investment opportunities. Other investors may simply look to ratings as an important indicator of default risk or risk/reward. However, ratings tend to be lagging indicators of deteriorating credit quality and default risk. In light of that, PIMCO developed an in-house ratings framework reflecting our own assessments of macro, issuer idiosyncratic, and granular bottom-up risk characteristics for each cover pool. We feel this helps us better navigate risks, whether top-down or bottom-up, before they get priced in; and it also helps us exploit market dislocations where bottom-up or top-down valuations are undervalued. Effectively, we attempt to stay one step ahead of ratings migrations from major rating agencies which trigger market repricings.
Also, while there has never been a recorded default in the covered bond market, default risk is a non-zero probability. There have actually been several close calls over the last decades when valuations for particular issuers or entire segments have repriced and traded at significant discounts for prolonged periods of time. In addition to fundamentally driven market repricings, technically or liquidity driven valuation dislocations within the asset class can persist due to market segmentation of investor bases across the multitude of currencies and country jurisdictions due to predominantly buy-and-hold investor base.
Continuous innovation in covered bond structures also requires structural finance competencies to properly assess inherent risks and whether investors are appropriately compensated for taking them.
Lastly, the global expansion of covered bonds offers frequent opportunities and potential diversification benefits. We have been instrumental in helping several legal jurisdictions and individual new entrants bring inaugural covered bond programs to market and often provided anchor orders in debut transactions.
For all of these reasons, we believe expert investors using an active approach have an edge when investing in covered bonds. Counterintuitively, the default remoteness which is so central a characteristic of the asset class actually introduces advantages to an active approach. These advantages have revealed themselves through consistent outperformance and high information ratios. Extensive due diligence and rigorous research into the risks of covered bonds and drivers of valuations are key to our covered bond strategy; this is why we strongly believe in our ability to consistently deliver alpha from an active approach.
Q: What is PIMCO’s approach to covered bond investing?
Mierau: We use a three-pronged analytical approach to estimate the possible future performance path of a covered bond and help us to identify broad and idiosyncratic opportunities across the global market.
First, we identify and analyse the country risks associated with each individual issue or issuer. Here, PIMCO’s macroeconomic forecasting and policy analysis provide invaluable insight.
Second, we have regular due diligence meetings with issuers to help us evaluate the dynamic characteristics and credit risks of the financial institutions that issue covered bonds. We analyse these banks to understand their future funding needs, ability to honour existing financial obligations, capital structure, and competitive position within the financial industry. These key factors guide us in determining both fundamental and relative value between covered bonds.
Third, we evaluate the strength of the covered bond collateral pool on both a quantitative and qualitative basis. We have developed an analytical approach that leverages structured finance techniques to analyse and model covered bond pools, and we utilise a proprietary cash flow model to stress-test these pools under a variety of economic scenarios. We also take great care to assess different legal and regulatory frameworks across jurisdictions.
Q: What opportunities does PIMCO see in the covered bond market today?
Mierau: We see persistent, ongoing opportunities across the continuum of the covered bonds universe driven by the diversity of the asset class (which now spans emerging and developed markets, and credit ratings from below investment grade to AAA), the dynamic nature of cover pools, frequent structural innovations, and a steady pipeline of new entrants. Opportunities can also take the form of providing liquidity in the primary or secondary markets or arbitraging fundamental or technical dislocations that persist due to market inefficiencies driven by minority participation by value-driven investors. Monetary policy and politics also are playing an increasingly strong role in valuations and liquidity, and policy implications can present opportunities for covered bonds investors.
There are also subclasses or niches within the AAA covered bond segment that present compelling risk/reward profiles along with extremely efficient market liquidity and pricing mechanisms. The Danish mortgage market, for example, has grown to become the largest covered bond country jurisdiction with approximately €380 billion outstanding. Within the AAA segment, Danish callable mortgage bonds (€165 billion outstanding) have a pure pass through feature that introduces optionality stemming from borrower prepayment behavior, and requires sophisticated quantitative techniques to price and assess valuations. As a pioneer in the U.S. mortgage-backed securities market, PIMCO developed a Danish mortgage pricing model through synergies from existing technology and expertise. We have been involved in the asset class since 2010 after discovering this structurally cheap embedded optionality, and we continue to see the asset class as a positive risk/reward outlier. Investment in these instruments has allowed us to effectively shift the efficient frontier higher for the PIMCO Covered Bond ETF.
Q: Can you speak to PIMCO’s experience with managing covered bond portfolios?
Mierau: PIMCO started investing in covered bonds over 20 years ago, when the market predominantly consisted of German issuers. As the issuers and issues proliferated over time, we expanded our resources to better analyse the different legal frameworks and risks associated with each security. Today, our dedicated covered bond team consists of five portfolio managers, averaging more than 10 years of experience, and 15 credit analysts.
Given our history and experience in the asset class, we have established individual relationships with most covered bond issuers and, as a large liquidity provider, we have exceptional access to the primary and secondary markets. This ability to source and allocate from both markets helps to lower transaction costs for investors. Over the years, we have also developed a suite of quantitative tools to assess the risk in individual covered bonds. We harness the collective experience of our dedicated team of portfolio managers and analysts to inform our investment strategy and target the most attractive covered bond opportunities.
Q: What is the PIMCO Covered Bond ETF?
Mierau: The strategy enables investors to gain exposure to the covered bond market and access PIMCO’s covered bond investment capabilities – all through an actively managed exchange traded vehicle (ETF). Launched just over six years ago, the Covered Bond ETF (COVR) leverages our full investment process: from top-down macroeconomic forecasting to bottom-up security selection; from country-level sovereign and legal framework analyses, to company-level financial credit analyses, to loan-level collateral and structure analyses. It is designed for a wide range of investors from individual investors to regulated institutional investors such as banks and insurance companies.
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