BlackRock Sounds Covered Bond Collateral Alarm: Credit Markets

The world’s biggest investors are warning that a plan to introduce new collateral into the $3.5 trillion covered bond market risks undermining the safety of securities pioneered in 18th-century Prussia.

BlackRock Inc. said using loans to small- and medium-sized companies, or SMEs, to back the securities rather than safer real estate or public-sector debt may devalue the asset class. Pacific Investment Management Co. said the first European deal, being marketed now by Commerzbank AG, may call into question SME issues as true covered bonds if it fails to qualify for indexes benchmarking performance.

“We should be very protective of the covered bond market because it’s had certain features for so many years, including the resilience of the collateral, and it’s a very safe asset class,” said Jozef Prokes, a London-based fund manager at BlackRock, which oversees $3.79 trillion as the world’s largest money manager. “We don’t think these are covered bonds.”

Germany’s second-biggest bank is selling the notes with junk-rated company loan collateral after exiting property lending, where losses helped trigger an 18 billion-euro ($24 billion) state bailout in 2009. Europe’s real estate slump curbed global covered bond sales to 34.5 billion euros since Jan. 1, the slowest start to a year since 2009 and less than half the 87.8 billion euros issued in the same period last year.

Program Created

Frankfurt-based Commerzbank set up a 5 billion-euro program to sell the notes in December. The first securities will be guaranteed by the lender and a pool of 650 million euros of company loans, according to a presentation to investors seen by Bloomberg News.

More than 75 percent of the collateral will be high-yield debt, though the bank guarantee means the notes are due to be ranked AA by Fitch Ratings, its third-highest investment-grade ranking, according to the presentation.

In grading the bonds, Fitch assumed a recovery rate, or the percentage of a defaulted loan repayable in foreclosure or bankruptcy, of about 8.8 percent for the underlying company debt. That compares with 58 percent to 87 percent that Fitch assumes on German mortgage-backed covered bonds.

Karsten Swoboda, a spokesman for Commerzbank in Frankfurt, declined to comment on the deal or the investors’ concerns.

Index Decision

A decision on whether the Commerzbank notes will be admitted to indexes will be taken after they’re issued, according to the bank’s presentation. Markit Group Ltd. and Barclays Plc administer two of the most popular indexes.

“For this asset class to be recognized it’s key to see whether the deal is admitted in the Barclays or iBoxx covered bond indexes,” said Timo Boehm, a Munich-based fund manager at Pimco, manager of the world’s biggest bond fund. If they aren’t, he said, “investors may question the nature of the asset class as a real covered bond.”

Elsewhere in credit markets, the cost of insuring company debt was little changed in Europe while U.S. markets are closed for a holiday. ThyssenKrupp AG, Germany’s biggest steelmaker, was among companies to raise money in debt markets.

The Markit iTraxx Europe Index of credit-default swaps tied to 125 investment-grade companies held at 113 basis points as of 3:03 p.m. in London, according to prices compiled by Bloomberg. The gauge, which investors use to hedge against losses or speculate on creditworthiness, declined three basis last week, snapping four weeks of increases.

U.S. Risk

The Markit CDX North American Investment Grade Index of swaps dropped 2.4 basis points last week to a mid-price of 86.9 basis points. The gauges typically fall as investor confidence improves and rise as it deteriorates.

Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Essen-based ThyssenKrupp sold 1.25 billion euros of bonds due August 2018 in its first benchmark-sized deal in a year. Bayerische Landesbank, Citigroup Inc., HSBC Holdings Plc and UniCredit SpA managed the sale, said a person familiar with the matter, who asked not to be identified because the deal isn’t public.

The extra yield that investors demand to hold company debt around the world instead of benchmark government securities fell to 146 basis points, or 1.46 percentage points, from 149 basis points on Feb. 8, according to Bank of America Merrill Lynch’s Global Corporate Index. The spread touched a three-year low of 142 basis points on Jan. 4.

Sales Slump

Sales of company debt worldwide declined to $40.9 billion last week, from $53.8 billion in the five days to Feb. 8, according to Bloomberg data. Vodafone Group Plc raised $6 billion in the largest dollar issue in almost a month as the world’s second-biggest wireless carrier was said to be preparing an approach to take over German rival Kabel Deutschland Holding AG as soon as this week.

Covered bonds started in 1769, when Prussia’s King Frederick let aristocrats, churches and monasteries raise money by pledging their estates as security. Denmark followed suit after the 1797 fire that destroyed Copenhagen.

Commerzbank’s issue may be about 500 million euros and have a maturity of five years, Fitch said when the debt program was announced. Covered bonds are cheaper for banks to issue than unsecured notes, with average yields falling to a record 1.95 percent, from 3.2 percent a year ago and 1.98 percent on Jan. 1, Bank of America Merrill Lynch’s EMU Covered Bond index shows.

In its presentation to investors, Commerzbank said it’s seeking to expand its base of SMEs by 15 percent in the next four years.

‘Physical Collateral’

Eberhard Hackel, a Frankfurt-based senior director at Fitch, said “at least two other issuers” are considering SME loan-backed covered bonds, without naming them.

Pricing of an SME loan-backed deal “should be wider than for traditional covered bonds, where you ultimately have recourse to physical collateral,” said Jean Michel Tremet, the Paris-based senior analyst for financials and covered bonds at AXA Investment Managers, which oversees the equivalent of about $382 billion. “This isn’t necessarily the case for SME loans.”

Commerzbank is seeking to sell the loan-backed notes as Europe’s share of the global covered bond market declines, according to Credit Agricole SA data.

Korea to Australia

European banks are taking advantage of investor demand for riskier securities to sell senior bonds that don’t tie up their assets, while covered bond issuance is springing up elsewhere in the world as new laws are implemented from Chile to South Korea and Australia.

Covered bonds yield an average 61 basis points less than corporate debt as measured by Bank of America Merrill Lynch’s Global Broad Market Corporate index. A year ago, the secured bank debt yielded just five basis points less.

Covered bonds earned investors 8.5 percent in the past 12 months, more than twice the gain for AAA rated German government bunds and six times that of U.S. Treasuries, Bank of America Merrill Lynch index data show.

European investment-grade corporate bonds returned 8.7 percent in the past year, the data show.

“While it makes sense from the issuer perspective trying to put more bonds under the label of covered bonds because the issuer can get better terms, the risk is the inherent quality features of the asset class end up diluted,” said BlackRock’s Prokes.

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