As the likelihood of Grexit has risen, so has the risk of the first default of a covered bond. Limited Greek outstandings mean the overall impact on investors would be small, but could such an eventuality test and ultimately damage the covered bond brand, particularly given how much its pristine track record has been emphasised?

When the European Parliament research service in January published a briefing note for MEPs on covered bonds asking whether the asset class is “ripe for expansion”, it was quick to state: “There has never been a default of a covered bond…”

This nugget has been a part of many a PowerPoint, particularly when issuers, intermediaries and lobbyists have been pitching those new to covered bonds – investors, potential issuers and regulators – around the globe.

It is not hard to understand why, particularly when the financial system has just gone through such severe stresses. Even in cases such as Washington Mutual and Iceland covered bondholders lost nothing.

Yet a Greek exit from the euro could prove too much for even covered bonds, given the risks that redenomination of the underlying mortgages would bring at the same time as a collapse of the country’s banks and economy.

Such a scenario is not yet inevitable, but the challenge it would pose to covered bonds is clear.

“While Grexit is now a base case scenario for most investors and analysts, there would still be many steps between that and a Greek issuer defaulting on a covered bond,” says Ted Packmohr, head of financials and covered bond research at Commerzbank. “However, it is a risk, and a test of the covered bond model in general.

“If it is likely to happen in the first place is a whole other question, but if we were to find out the model doesn’t work, that is a problem.”

In the aftermath of a covered bond default, he says, the market would have to investigate the exact reasons that bondholders’ protections failed and evaluate whether a similar scenario could occur in other jurisdictions.

“Definitely it could shake investors’ confidence, and the general belief that covered bonds are waterproof would have been proved untrue,” says Packmohr. “But then we would have to look at exactly what went wrong and how this can be transferred to other countries.”

Some bankers suggest that investors and regulators would recognise the unprecedented nature of the Greek crisis and make a distinction between Greek covered bonds and those from other jurisdictions.

“I would not rule out that covered bonds get into the political maelstrom and put some losses to the ECB account,” says Ralf Grossman, head of covered bond origination at Société Générale. “You can always create a maximum stress which even a covered bond could not withstand.

“But that is a very special situation that I think that international investors would acknowledge.”

Grossman says that he therefore would not expect a negative impact on the covered bond brand.

“I don’t think this would materially change the covered bond pitch since it’s a very specific and worst case situation and investors understand the mechanics of the covered bond product,” he says.

“I could only imagine an impact on covered bonds from other countries if there would be speculation on further euro exits.”

A funding official at a German issuer also questions whether the comparison between Greek covered bonds and those from other issuers would be valid.

“Is it fair to talk about a potential default of a weak covered bond asset and legislation in Greece as if it might be a problem for covered bonds from all other countries, especially core countries?” he asks. “I don’t think it is.”

He says there is a huge difference between Greek covered bonds and core covered bonds, as is shown in the collateral and reflected in pricing levels.

“I don’t believe that a potential default of a Greek covered bond would be enough to start a general discussion about the security mechanism of covered bonds overall,” he says. “Or at least I don’t want to believe that.”

Commerzbank’s Packmohr says there is a distinction between Greek covered bonds and others because of probable lower levels of systemic support in Greece than elsewhere, and because outstanding volumes are low and mostly internally placed.

He nevertheless notes that Greek covered bonds are issued according to legislation similar to those used in many other countries.

“You have the basic ingredients in the Greek legislation and Greek covered bonds are accepted as a covered bond product,” he says, “so in that sense what happens to Greek covered bonds is transferable to other countries, and this crisis will be taken as a yardstick to some degree.

“If the same loopholes were found in other countries then that is certainly something investors would take into consideration in making their spread evaluations, and issuers and regulators would take into consideration in future adjustments to legislation and regulation.”

The impact could include a new regulatory push, Packmohr says.

“If these risks were found to be transferable it could have a great impact on the market, in steering the market onto a different path,” he says.

“But it would not mean an end to the status of the covered bond as a safe product.”

Daniel Loughney, portfolio manager at Alliance Bernstein, says that were there a default on a Greek covered bond, the impact would depend on whether this resulted from a weakness in the collateral or from the relevant legislative and regulatory protections not holding up.

“If for some reason whatsoever due process is not followed, that would be very problematic for the covered bond product going forward” he says. “At the moment, investors effectively take regulations as given, to a large extent, while they undertake credit work on the underlying collateral.

“But if it’s a credit issue, it is not a problem if a Greek covered bond defaults. Then we would get more relative value, and more sensible differentiation between jurisdictions.”

Indeed he says that such an outcome could be healthy.

“I never liked the pitch that no one has ever lost money on a covered bond,” adds Loughney. “You’re always going to tempt fate, and you’re only as good as your underlying collateral.

“When people buy covered bonds they should realise it is a credit product, and there are some risks,” he said, “even though those risks are far less than with other instruments.”

Photo: Thermos/Wikimedia Commons