Pimco Cools on Covered Debt After Record Rally: Credit Markets

Europe’s covered bond market is falling out of favor with Pacific Investment Management Co. after a record rally sent relative yields to a three-year low.

“Investors are looking for other asset classes where they can achieve a better return on their risk,” said Timo Boehm, a money manager focusing on European covered debt at Pimco, which manages about $2 trillion of assets including the world’s biggest bond fund. Some highly rated alternatives including sovereign-backed and agency notes are “much cheaper,” he said, speaking by telephone from Munich last week.

Euro-denominated covered notes yielded 63 basis points more than swap rates in May, down from last year’s high of 208 basis points in January and the least since April 2010 following the steepest rally in Bank of America Merrill Lynch data going back to 1996. The securities, sold in Europe since the 18th century and backed by mortgages and public sector loans, are about the most expensive relative to quasi-government bonds since 2008.

Pimco has reduced bets on covered notes after previously holding a greater percentage than is contained in the benchmarks it tracks, Boehm said. Global sales of the debt slumped 43 percent to $136.1 billion this year as a European central bank funding plan and sluggish credit growth in the recession-plagued region deterred issuance, data compiled by Bloomberg show.

New Markets

Yields on European covered bonds have plunged to an average 1.66 percent, from 5.43 percent at the height of the financial crisis in 2008, the Merrill Lynch indexes show. Italian lender UniCredit SpA’s 1 billion euros ($1.3 billion) of 4 percent covered notes due January 2018 yielded 97 basis points more than swaps as of June 14, Bloomberg prices show. Similar-maturity Italian government bonds offered a 217 basis-point spread.

The securities, which are generally guaranteed by the issuer with the assets staying on their balance sheets, are highly rated. More than 60 percent of Bank of America Merrill Lynch’s covered bond index is graded AAA, boosting their appeal when risk-sentiment deteriorates.

“Investors definitely have appetite for covered bonds, which is why they are trading extremely tight,” said Lucette Yvernault, a London-based fund manager at Schroder Investment Management Ltd., which has about $359 billion invested.

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increased 0.7 basis point to a mid-price of 82.6 basis points as of 10:57 a.m. in New York, according to prices compiled by Bloomberg.

The index typically rises as investor confidence deteriorates and falls as it improves. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.7 basis point to 17 basis points as of 10:56 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Chevron Corp. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 9.8 percent of the volume of dealer trades of $1 million or more as of 10:59 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Investment Grade

The second-largest U.S. oil company sold $6 billion of bonds yesterday in a four-part offering, Bloomberg data show. Its $2.25 billion of 3.191 percent, 10-year notes issued at par rose to 100.654 cents on the dollar to yield 3.114 percent, Trace data show.

The Bloomberg Global Investment Grade Corporate Bond Index has gained 0.78 percent this month, paring the decline for the year to 1 percent.

Investors have earned more from holdings of euro-denominated covered bonds this year than debt sold by eurozone sovereigns or investment-grade companies in the region.

The securities returned 2.2 percent in 2013, including reinvested interest, as government bonds and company debt each gained 1 percent, Bloomberg indexes show. Spreads closed June 14 at an average 74 basis points, according to Bank of America Merrill Lynch indexes.

Investors, borrowers, analysts and policy makers are gathering in Brussels this week to discuss the asset-backed securities market, including covered bonds, at a conference put on by the Information Management Network and the Association for Financial Markets in Europe.

Australia, Belgium

Offerings outside Europe are accounting for a larger portion of the market as traditional issuers stay away. Sales in currencies other than the euro comprised 29 percent of the total, from 18 percent in 2010, the data show.

Banks from Australia to Belgium have started issuance in the last two years, while South Korea and Singapore are mulling legislation to follow suit.

Covered bond sales this year are likely to fall short of forecasts, with lenders on pace to sell 80 billion euros to 100 billion euros of benchmark securities, Pimco’s Boehm said.

Spanish mortgage lending fell to 3.1 billion euros in March, a decline of 90 percent from the peak of the credit boom in January 2007, Spain’s national statistics institute said May 28. U.K. lenders have approved an average 51,700 mortgages a month since June last year, about half the average in the decade before the financial crisis struck, Bank of England data show.

‘Gaining Traction’

The U.K.’s Funding for Lending Scheme and a European Central Bank financing program are helping banks access cash to encourage lending, which is further reducing lenders’ reliance on bond investors.

Some banks are taking advantage of the pent-up demand to use new collateral types to sell notes. Covered bonds supported by loans to small- and medium-sized enterprises are “gaining traction as a new funding tool,” Moody’s Investors Service wrote in a report this month.

Commerzbank AG paid 94.2 basis points more than government debt to sell Europe’s first notes backed by the asset class in February, data compiled by Bloomberg show. German issuers pay an average 25 basis points more than the sovereign benchmark to sell covered debt, Merrill Lynch indexes show.

While European credit growth has shown some signs of recovery, the extra bank funding needs aren’t yet trickling into bond markets, said Gareth Davies, head of European asset-backed securities research at JPMorgan Chase & Co. in London.

“Lending is moving in the right direction in Northern Europe, but it’s from such a low starting point that there’s little for people to be shouting about,” Davies said.

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