Covered Bond Crumbs Failing to Satisfy European Appetite

Covered bonds are paying European buyers so little that one of the $3.3 trillion debt market’s biggest investors is scaling back holdings.

Union Investment Institutional GmbH, which oversees 21 billion euros ($27 billion) of the notes, will no longer reinvest proceeds from maturing debt into the securities, said Daniel Rauch, a Frankfurt-based money manager. The average yield on the bonds declined to a record 0.53 percent, according to Bank of America Merrill Lynch index data.

“Do we need to go for the last breadcrumbs when we feel we’re not being compensated enough?” Rauch said. “Returns have been good but we’ve now reached a yield level where an investment in covered bonds isn’t very attractive any more compared with other assets.”

The 250-year-old debt market helps fund Europe’s mortgage industry and the notes have historically been attractive to investors because they’re guaranteed by the issuer and backed by a pool of assets. Unsecured investment-grade bank bonds yield more than twice as much at 1.24 percent, the biggest difference in two years, Bank of America Merrill Lynch index data show.

Canadian Imperial Bank of Commerce sold 1 billion euros of five-year notes last week priced to yield 0.45 percent, according to Deutsche Bank AG. Belgian lender Belfius Bank SA/NV paid 0.74 percent to sell 1.25 billion euros of debt on Oct. 6, according to data compiled by Bloomberg.

ECB Purchases

With maturing debt outpacing new issues for a second year, covered bond yields are forecast by analysts to remain low as the European Central Bank prepares to buy the securities as part of its program to revive economic growth.

“Some people feel the outright yield level is wrong,” said Armin Peter, head of European debt syndicate at UBS AG in London. “It feels strange to be this low, but that’s because we are in unchartered territory.”

After six-years of maintaining interest rates at 1.5 percent or less, purchases of covered bonds are the latest addition to the unconventional tools the ECB is using to boost an economy that the International Monetary Fund says has as much as a 40 percent chance of entering its third recession since 2008. The central bank, which said last week that 600 billion euros of covered notes are eligible for purchase, also proposes buying asset-backed securities, such as bonds backed by auto loans.

Nuanced Approach

The extra yield investors demand to hold covered bonds compared with government debt dropped to 33 basis points, a seven-year low, according to Bank of America Merrill Lynch index data. That’s more than they got before the credit crisis, when the spread averaged 19 basis points between 2001 and 2006, reaching a low of 11 basis points in 2005.

Covered bonds returned an average 5.2 percent annually since 2000, which is less than the 5.4 percent for buyers of investment-grade company debt and the 5.3 percent for junk-rated corporates.

Investors should take a considered approach to the debt, according to Ralf Burmeister, a Frankfurt-based fund manager at Deutsche Asset & Wealth Management. The firm oversees 955 billion euros of assets, including about 15 billion euros of covered bonds.

“The level of yields is concerning and certain covered bonds, such as German bonds maturing in three years or less, have stopped making economic sense,” said Burmeister. “That doesn’t mean it’s time to abandon the market though as longer-dated German bonds and those from other countries are still investable.”

Bond Returns

Union Investment has placed money from maturing securities outside the covered bond market since the beginning of the year and is now “fully convinced” its strategy is appropriate, said Rauch. The firm is using the proceeds to buy government notes, including those issued by nations in the region’s periphery, said Rauch.

The asset manager doesn’t plan to sell bonds that haven’t matured, said Rauch. That will allow the company to benefit from the longest winning streak for the debt in five years.

Investors in the notes earned 0.62 percent in September, the ninth consecutive month of positive returns, according to Bank of America Merrill Lynch index data. That compares with the 0.19 percent earned on investment-grade company debt and a 0.92 percent loss from high-yield securities.

“We have a lot of redemptions coming up and we don’t intend to invest that money in covereds again,” said Rauch. “Negative net issuance has led to a crowded one-way market that suits issuers not investors and now there’s a new big guy in the room.”

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