Investors consider sovereign risk to be the greatest challenge facing the covered bond market, according to a Fitch survey released this week, but a new Crédit Agricole index found that market participants have been expecting conditions for covered bonds from peripheral countries to improve.

Fitch also asked investors what they expect to happen to their covered bond holdings in the next 12 months

A Fitch questionnaire asked investors to indicate the biggest challenge to the covered bond market and the largest percentage of votes (37.2%) went to sovereign risk. Underlying collateral performance came in second place (21%), with other concerns being secondary market liquidity (15%), health of the banking sector (15%), regulatory treatment (8%), and other factors (4%).

Eighty-two investors, primarily based in Europe, were polled in December. The majority of respondents, 58%, had less than Eu5bn of covered bonds under management, while 34% had between Eu5bn and Eu50bn, and the remaining 8% upwards of Eu50bn.

The survey revealed a greater willingness on behalf of investors to embrace covered bonds rated lower than triple-A, which has become a more common occurrence given the structural changes and ratings pressure the market has faced.

Non-triple-A covered bonds were seen as more attractive by participants than in the past; 88% of the investors were willing to examine non-triple-A covered bonds. That group comprised a 14.6% share who said a triple-A rating is irrelevant and 73.2% who agreed that a triple-A rating is important but that they would still be willing to purchase non-triple-A issues.

Hélène Heberlein, managing director, covered bonds, at Fitch, said she was surprised to find that “some investors are disregarding the covered bond rating and looking at the bank rating first”.

However, a triple-A rating was still viewed as “very important” by 84.2% of respondents and rating agency research was listed as the most important consideration when investors were asked to prioritise factors for monitoring covered bond holdings.

Fitch's Heberlein: Some investors look at bank ratings first

Investors are willing to accept pass-through covered bonds, according to the survey. The majority of investors (52.5%) would consider purchasing either partial or full pass-through covered bonds, with another 9% uncommitted to a definite yes or no. Only 38.8% refused to even consider non-bullet payback structures.

Deutsche Bank analyst Bernd Volk said he was surprised by the willingness of investors to accept pass-through covered bonds when “all existing pass-through covered bonds are on balance sheets of central banks for repo reasons”.

“A pass-through structure would reduce overcollateralisation requirements,” he said, “and hence allow higher covered bond issuance, i.e. the need for expensive unsecured funding would be reduced.”

Heberlein cautioned that the diversity of investors polled must be taken into consideration when noting this result.

“If you had conducted this survey primarily among insurance companies and pension funds, they would probably have said they only want hard bullets,” she said.

Inclusion of RMBS as cover pool assets has been a talking point, with two new issuers, Axa Bank Europe SCF and Intesa Sanpaolo, having been including senior tranches of RMBS in their cover pools. The survey found that 43% of investors were uncomfortable with this development, while the remaining group either viewed it as acceptable (19%), reasonable as long as they were compensated with higher spreads (20%), or stated no opinion (18%).

CSI finds evidence of peripheral optimism

A survey conducted at the end of January by Crédit Agricole for a new covered bond market sentiment index (CSI) found that in aggregate investors and issuers consider market and investment conditions to be better for core countries than for peripheral countries. However, while the results implied an expected improvement in conditions for covered bonds from peripheral countries, a deterioration was anticipated for those from core countries.

Feedback was gathered from 106 investors and 29 issuers for Crédit Agricole’s survey.

Eichert, Crédit Agricole: Issuers will always need complementary funding

Crédit Agricole noted that any concerns about the market have not stopped covered bonds from garnering more attention than ever before. January 2011 marked a record month for covered bond issuance, with just over Eu41bn of supply, and legislation – such as Basel III, Solvency II and EU bail-in proposals – expected to impact several funding tools but exempt covered bonds.

Legislative changes are encouraging many senior debt holders to make the switch to covered bonds, said Crédit Agricole’s report, but increased attention should does not mean the tool can or should replace other forms of funding.

“In our view, they are not, and cannot take over the function senior funding has fulfilled and is still fulfilling,” said Florian Eichert, senior covered bond analyst at Crédit Agricole. “Covered bond issuers will always need funding from other sources to complement their covered bond franchise.”