During the past few years, there has been dramatic growth in institutional investor acceptance and investment into pfandbriefe and covered bonds around the world. Most of the current benchmark issues are being placed with investors outside of the home country of the issuer. What is interesting to note is not so much the broad usage by various types of investors, but that the demand is often being driven by local considerations in the investors’ home markets.
What began as a German concept in 1768 has now been adopted in one form or another by many other European countries. In this year alone, there could be new pfandbrief/covered bond legislation in Norway, Sweden, Italy, Portugal and Belgium. Ireland has recently passed covered bond legislation through its parliament and the first Jumbo Irish covered bond issues (in excess of e1bn by today’s market standard) could come as early as the second quarter of 2002.
What is driving such a dramatic growth in demand for this instrument outside of the German market? The answer generally differs from country to country, although there are similar patterns by investor type internationally. In countries such as Australia, New Zealand, Canada and Japan, the local currencies have generally been very weak against the currencies of their major trading partners. Fund managers, insurance companies, and banking institutions in these countries have often found that taking a currency risk in an offshore investment has proved to be a more profitable way to bring good returns compared to investing at home in the local currency. In the rest of Asia, and increasingly in the Middle East, there has been a strong demand from central banks to invest larger portions of their foreign currency reserves in the pfandbrief and covered bond markets.
Central banks in Eastern Europe (including those of the former Soviet republics) have been increasing their investment in the pfandbrief and covered bond markets.
In Western Europe, the general trend has been towards increasing investment in the pfandbriefe/covered bond markets. In Scandinavia, there has been a general awareness of the pfandbrief/covered bond concept due to the long-existing, well-developed mortgage bond markets in Denmark and Sweden. In addition, Finland has developed a mortgage pfandbrief law, modelled closely on the German legislation. Norway is in the process of drafting a version of their pfandbrief legislation based on a current Norwegian instrument called Panteobligasjon. The investor base has been varied in these countries. Finland, which has adopted the euro as the official currency, has a rapidly increasing investor base not only in pfandbriefe, but also in other covered bonds. Over the past two years, the Spanish Cédulas Hipotecarias market has been rapidly growing with an ever-increasing size in benchmark issues. The Finnish insurance companies and pension funds have found these instruments very attractive due to the spread they offer over the swap curve and the AAA-Spain risk in a liquid benchmark format without the Latin American downside credit problem. In Sweden, the larger insurance companies have found the pfandbrief/covered bond yields attractive to local alternatives. Danish pension laws have been recently changed to allow greater investment in covered bonds. Norwegian banks have been using the pfandbrief/covered bond instruments for their liquidity management and have found the growing repurchase markets in these instruments an extra advantage.

Germany has been traditionally the largest and most experienced investor base in the pfandbrief due to the local history and exposure to the instrument. As many German Hypothekenbanken and Landesbanken merge, many German investors are finding that their new exposure to the merged entity encroaches on their legal exposure limit to one entity. Therefore, there has been a lot of diversification in the German investor based towards the new covered bond alternatives in France, Luxembourg, Spain and, soon, Ireland.
In France, the French Obligation Foncière market has been a catalyst for the French insurance companies and investment funds to get involved in this market. These investors have tended to find the spread over the OAT attractive as well as the liquidity from the market making requirements of the bookrunners. The French pfandbrief equivalent of Obligation Foncière has true bankruptcy-remoteness and has been generating an increasing amount of investment due to some of the downgrading of public-sector and mortgage pfandbrief issued by prominent German names. In the French legislation, the assets are put in a separate operating company, a Socíété Crédit Foncier. In pfandbrief, the assets backing the issues are still on the balance sheet of the general operating company.
In Spain, the 130-year old Spanish Cédulas Hipotecarias market has been growing by over 100% in Jumbo volume issuance each year over the past two years. Investors in the EU have these instruments attractive due to spread, the healthy credit story behind the instruments, the ratings, and liquidity.
AyT Cédulas Cajas has appeared with a new form of covered bond issuance in this market. In pooling several Spanish savings banks’ mortgage funding needs together, AyT was able to form a large benchmark issue that would have appeal to investors throughout the EU. In both issues of AyT Cédulas Cajas, the investor demand was very strong. The investors liked the standard aspect of covered bonds, and found the credit diversification within one issue new and attractive. The AyT Cédulas Cajas model has enabled smaller institutions to be able to gain access to this market as issuers on the same footing as the larger institutions.
It has democratised the covered bond market and there is a chance that this model will be used in the new markets of Italy and Ireland where a lot of smaller banks which to participate as issuers in the covered bond market this year. Due in large part to the Spanish Cédulas Hipotecarias increased benchmark issuance, Spanish insurance companies, pension funds, and large mutual funds have not only started heavily investing in these instruments, but the covered bond markets of the other countries as well.
Italian insurance companies, investment funds, and pension funds have been increasing their activity in covered bonds as well. Many covered bonds offer the magical yield of ‘BTPs plus’ (an attractive yield over Italian government bonds) as well as performing well in terms of spread over other European government bonds.
As can be seen by the chart, pfandbriefe (shown by the black line: PEX 10-year) over time have outperformed government bonds (shown by the green line: REX 10-year). In other words, e100 invested in Janaury 1995 would have yielded e165 in January 2002 through pfandbriefe investment, compared to e147 invested in government bonds. What is interesting to note is the performance of the share market (as represented by the red line: DAX). e348 invested in shares in January 2000 would be worth e252 in January 2002.
This movement from shares into fixed income and especially into the pfandbriefe and covered bond markets have been especially noticeable among the large Dutch and UK investment managers. There are over 80 Dutch institutional investors in the pfandbrief and covered bond markets on a regular basis in our opinion. The involvement in the markets from UK investment management groups (IMGs), Scottish pension funds, and Irish asset managers is strong and growing rapidly. Although the pound sterling is still the currency of the UK, there are increasing portfolios in euros in the UK that are being directed to the pfandbrief and covered bond markets. Some covered bond issuers such as Eurohypo of Germany and Compagnie de Financement Foncier of France, for example, have issued pfandbriefe and covered bonds in sterling to further develop the investor base in the product.

As these investors study their portfolios under management, they see the different types of pfandbriefe and covered bonds purchased by the fund manager and learn about the instruments. As they observe the improvement in returns of the covered bonds compared to government benchmark stock, they often start to invest in these instruments on their own as well.
Swiss institutional investors have also been drawn to the market. Many covered bond issuers (Eurohypo Luxembourg in particular) have tailored issues for placement into the Swiss retail market. Some benchmark covered bond issues have been put on Swiss retail buy lists.
Supranational investors are also purchasing more of these instruments due to the prime quality, yield enhancement over government bonds, and liquidity from the market-making requirement of the bookrunners. Their focus is mainly in the public-sector covered bond; preferably from the public-sector issuers as well. Several supranational investment funds have found the positive spread yield (from where they themselves borrow) an attractive way to place funds until the money is needed for other projects.
Although there has been some concern among investors over recent downgradings of certain pfandbrief issuers, the volume of investment in the pfandbrief and covered bond sector is growing throughout the world. New legislation from Ireland and the draft pfandbrief law in Italy is aimed at improving on exisiting legislation in the other markets. With this trend to improve the legal framework, these new laws should continue to open up greater numbers of investors into this market. Many of the issuers are restructuring their businesses to appeal to the growing investor base abroad. They are adopting book building practices to show true pricing transparency in the issues which should continue to attract money into this sector.
Ted Lord is director and head of covered bonds at Barclays Capital in Frankfurt