How to capture opportunities in the European Covered Bond market

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Henrik Stille, Portfolio Manager of Nordea’s Covered Bond Strategies

With around EUR 3 trillion outstanding bonds, the European covered bond market is the second largest Fixed Income market in Europe after government bonds. To put that in perspective, Denmark alone has outstanding covered bonds worth EUR 455 billion – that almost corresponds to the size of the entire European high-yield market – followed by Germany (Pfandbriefe), France (Obligations foncières), Spain (Cédulas hipotecarias) and Sweden with EUR 391, 350, 243 and 242 billion of assets respectively.

Covered bonds offer many advantages, yet they seem sometimes to be the forgotten piece of the fixed income markets. Many benefits come from a structural allocation to covered bonds thanks to their safety, regulatory treatment, liquidity and diversification potential. The compelling features of covered bonds make the case for the asset class to find its place in investors’ portfolio, alongside the traditional government and corporate debt investments.

In general, covered bonds behave in a similar way as other credit products, yet with a lower overall credit beta. In a risk-on environment cover bond spreads will tighten, but not as much as other credits. On the other hand, covered bond spreads will typically widen in a risk-off scenario, but not as strongly as other credit products. The low credit beta and the low volatility are appealing features of the asset class within a portfolio context.

Nordea’s Danish Fixed Income and European Covered Bonds Team is one of the largest in the market, managing over €38bn, with a track record of over a decade. The team builds on its deep understanding of Scandinavian covered bond markets, giving our solution a special edge in the process of building a covered bond portfolio. Scandinavian covered bond markets are made up of both very strong banks and strong cover pools backed by residential mortgage loans of very high quality.

Active management, low duration and flexibility : essentials to make the difference?

Last year was overall quite negative for every asset class (including government, corporate and high yield bonds), with the market focusing on recession risk over the summer and energy prices sending inflation soaring. And after a long period of falling yields, the market has finally turned. In order to counter this uncertain environment, active management of Fixed Income strategies is a potential key to success. We believe the covered bond market offers exactly what we need: a strong underlying asset quality (no defaults in the asset class’s 200-year history), strong liquidity and inefficiencies that can be turned into alpha opportunities.

Covered bonds remain a very low-risk asset class…

Covered bonds are high-quality debt instruments issued by mortgage institutions or banks, which are backed by a pool of assets. Thus, investors benefit from a dual protection. The first recourse is a full claim on the issuer’s assets – which means should the issuer becomes insolvent, covered bond investors have creditor rights on the assets. The second recourse is a preferential access to the cover pool. Generally, the cover pool consists of high quality mortgages (housing or non-residential) and/or public sector loans. The lowest standard is that the cover pool’s value cannot be lower than the value of the covered bonds issued. Yet, cover pools are generally over-collateralized at more than 100% of the issuance value, depending on the jurisdiction.

EU regulatory enhancements have granted covered bonds preferential treatment: the asset class benefits from both banking and insurance regulation frameworks. In addition to being one of the most senior debts on financial institutions’ balance sheet, an extra layer of investor protection is added by covered bonds’ exemption from the EU bail-in mechanism, which gives covered bond investors an exemption from sharing losses if the issuing bank falls into financial difficulties. As a result, covered bonds have not witnessed a default in more than 200 years of history.

…with attractive solutions adapting to the inflationary environment

Duration has been the main contributor to volatility for many asset classes recently. In Nordea’s European Covered Bond Opportunities Strategy, we seek to construct portfolios that are insensitive to actual changes in interest rates – a duration-hedged approach which has proven its effectiveness. Our European Covered Bond Strategy takes a more neutral approach to duration, and is managed broadly in line with the benchmark’s duration. Covered bond spreads are currently trading near record highs since the sovereign debt crisis. At the same time fundamentals are very healthy and in general loan to values are stronger than pre-pandemic. The increase in spread in 2022 was in fact driven by supply dynamics as banks frontloaded the issuance of covered bonds whereas government bonds are backloading new issuance. A reverse of the above mentioned dynamic would prove beneficial for covered bond performance relative to government bonds in our opinion.

The value of focusing on active management in case of recession

As hectic markets call for flexibility, the Nordea European Covered Bond Opportunities Strategy is not giving up on all inefficiencies and investment ideas that can only be sought with an active/higher turnover approach. Indeed, our value proposition is closely linked to the added value of active management. This is where the expertise of our Danish Fixed Income & European Covered Bond Team in the covered bond market plays its full role. We seek relative value opportunities, allocating mostly in Covered Bonds, selectively in Government Bonds. As one of the largest manager of covered bonds in Europe with decades of experience the complexities of the market offer us a wide range of opportunities, as we are truly dynamic in our allocation. We have the opportunity to invest outside of the EUR-denominated universe (with no currency risk as the portfolio is hedged to EUR). We leverage on our expertise in the Nordic markets and take advantage of ratings inefficiencies and market players’ constraints. Divergences from fair values offer opportunities to us – and we actively pursue them in order to add value to our investors. Given the uncertainties in financial markets, we believe Nordea’s Covered Bond Team is uniquely positioned to offer a strong and active cornerstone for investors in search for high quality assets. Our skill driven, benchmark agnostic approach can make a difference! 1
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