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Kristion T. Mierau, Howard F. Chan
Covered bonds are an asset class with a long history in Europe. Long considered an attractive, “safe,” high quality alternative to traditional European government bonds and senior unsecured bank debt, covered bonds have seen a dynamic evolution in market structure and composition as well as increased demand due to regulatory changes, such as Basel III and Solvency II, and proposed bank resolution regimes. The PIMCO Covered Bond Strategy offers investors actively managed exposure to a diversified portfolio of global covered bonds. In the following interview, Kristion Mierau, head of European covered bond portfolio management, and Howard Chan, product manager, discuss the investment strategy, PIMCO’s expertise investing in covered bonds and the potential benefits an allocation to covered bonds may offer investors.
Q: What is the PIMCO Covered Bond Strategy? Mierau: The strategy enables investors to gain exposure to the covered bond market and access PIMCO’s covered bond investment capabilities. Developed and refined over the last 15 years to identify opportunities in the asset class, the strategy leverages PIMCO’s full investment process: from our top-down macroeconomic forecasting to bottom-up security selection; from country-level sovereign analyses, to company-level financial credit analyses, to loan-level collateral analyses. The Covered Bond Strategy is designed for a wide range of investors from individual investors, to regulated institutional investors like banks and insurance companies.
Q: What are the key characteristics of covered bonds? Mierau: Covered bonds are senior bonds issued by financial institutions; they are backed by a dedicated on-balance-sheet pool of collateral. The pool usually consists of mortgages and public sector loans. Covered bonds are structured to withstand an event of default of the issuer, and a covered bond does not automatically default when the issuer defaults. Investors in a defaulted issuer’s covered bonds have “dual recourse” to payment. First, the assets in the collateral pool are used to meet payments of the covered bond. Second, investors have claims to the issuer because covered bonds are unconditional obligations of the issuing financial institutions and are ranked pari passu to senior secured bonds.
The dual-recourse feature inherent in most covered bonds strengthens the perception of them being a “safe” asset class. For example, under the current European Commission’s proposed bank resolution directive that is expected to be implemented in 2018, covered bonds will be exempt from bail-ins. In effect, covered bonds may be considered to sit at the very top of the capital structure, above large uninsured depositors and senior secured bonds.
Chan: Covered bonds are the second largest private debt market in Europe, after senior unsecured bank debt. First recorded in Germany over 200 years ago, the asset class has been embraced across Europe and around the globe to North America and Asia-Pacific. The total value of benchmark-eligible covered bonds outstanding globally is now close to €1.1 trillion (according to Barclays). The covered bond market is well diversified and liquid, comprising around 150 different benchmark-eligible issuers. No covered bond has had a default since the advent of the asset class.
Although several covered bond issuers have failed, all of their respective covered bond programmes remained viable structures, either being subsequently acquired by going concern entities or wound down under state ownership.
Q: Who are the typical investors in covered bonds, and how do they invest in them? Mierau: Several different types of market participants invest in the asset class due to covered bond’s favourable risk/return profile. Historically, covered bonds have offered better returns and lower volatility than European government bonds, and also lower duration or interest rate risk. As a result, many investors use covered bonds as a substitute for European government bond allocations, aiming to improve the efficient frontier of their overall portfolio. Given the current level of yields and the dual-recourse feature of the asset class, it may also offer a good substitute for senior unsecured bonds.
Chan: Covered bonds also look fairly attractive for bank and insurance companies because of their favourable treatment under various regulatory regimes. For banks, covered bonds have lower risk-weighting under Basel III and are considered as “high quality liquid assets” under its Liquidity Coverage Ratio (LCR). For insurance companies, covered bonds have preferential treatment under Solvency II and offer attractive yield potential without incurring high capital charges.
Investors have several ways to incorporate covered bonds in a portfolio. Institutional investors typically buy and hold individual covered bonds, though others access covered bonds through actively managed commingled funds. Investors seeking portfolio transparency, intra-day liquidity or to meet regulatory requirements may also invest in covered bonds through exchange-traded funds (ETFs).
Q: Why should investors consider an active approach to covered bonds when this asset class has never experienced a default? Mierau: In the current investment landscape, we believe active management is crucial to covered bond investing. Years ago, the covered bond asset class was largely homogeneous, but in the post-financial-crisis world, the asset class has become highly differentiated. We believe the global expansion of this asset class offers significant opportunities and the potential for diversification benefits. Also, despite no default in the past, investors need to be aware of new drivers of covered bond valuation and pricing, such as market perceptions of the strength of sovereign and bank balance sheets.
Additionally, continuous innovation in covered bond structures requires structural finance competencies to properly analyse valuation. A changing market backdrop in the asset class, combined with a traditionally buy-and-hold investor base, can result in prolonged fundamental valuation dislocations. As a result, investors can benefit from an active manager seeking to add value by exploiting these opportunities to outperform a broad covered bond benchmark.
Q: Can you speak to PIMCO’s experience with managing covered bonds? Mierau: PIMCO started investing in covered bonds 15 years ago, when the market was predominantly comprised of German issuers. As the issuers and issues proliferated over time, we expanded our resources accordingly to better analyse the different legal frameworks and risks associated with each security. Today, our dedicated covered bond team consists of five portfolio managers, averaging more than 10 years of experience, and 15 credit analysts.
Given our history and experience in the asset class, we have established individual relationships with most covered bond issuers and, as a large liquidity provider, have exceptional access to the primary and secondary markets. This ability to source and allocate covered bonds from both markets helps to lower transaction costs for investors. Over the years, we also have developed a suite of quantitative tools to assess the risk in individual covered bonds. We harness the collective experience of our dedicated team of portfolio managers and analysts to inform our investment strategy and target the most attractive covered bond opportunities.
Q: What is PIMCO’s approach to covered bond investing? Mierau: We believe there are three main risks when investing in covered bonds: 1) sovereign or indigenous risk driven by the country in which the issuers reside, 2) idiosyncratic risk of the issuer itself, typically the credit risk of a bank and 3) risks associated with the performance of the collateral pool of assets that backs the covered bond. To manage these risks, PIMCO employs a time-tested three-pronged analytical approach.
First, we identify and analyse the country risks associated with each individual issue or issuer. Here, PIMCO’s macroeconomic forecasting and policy analysis provide invaluable insight. In 2010, for example, our concerns regarding the unsustainable debt levels of the peripheral eurozone countries helped us side-step negative price pressure on peripheral covered bonds.
Second, we conduct due diligence visits to help us evaluate the specific characteristics and credit risks of the financial institutions that issue covered bonds. We analyse these banks to understand their future funding needs, ability to honour existing financial obligations, capital structure and competitive position within the financial industry. These key factors guide us in determining both fundamental and relative value between covered bonds.
Third, we evaluate the strength of the covered bond collateral pool on both a quantitative and qualitative basis. We have developed an analytical approach that leverages structured finance techniques to analyse and model covered bond pools, and we utilise a proprietary cash flow model to stress test these pools under a variety of economic scenarios. We also take great care to assess different legal and regulatory frameworks across jurisdictions.
This three-pronged analysis gives us crucial insight into the possible future performance path of a covered bond and helps us to identify broad and idiosyncratic opportunities across the global covered bond market.
Q: What opportunities does PIMCO see in the covered bond market today? Mierau: The covered bond market has had a very good run. As spreads have converged across the credit spectrum in recent years, some market participants have questioned long-term performance potential in the asset class.
Increasing diversity from new entrants along with structural innovations will present new investment opportunities and can lead to strong performance potential. Additionally, we anticipate further consolidation within banking sectors as well as a high probability of isolated distressed events, which present windows of opportunity for active investors to harvest attractive returns.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available in all jurisdictions or to all investors. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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