Covered bonds offer yield with security

Despite the pandemic – or perhaps because of the associated spike in real estate prices – covered bonds outperformed other fixed-income assets in 2021. The asset class is also expected to outperform in 2022, especially compared to government bonds, according to Henrik Stille of Nordea Asset Management.

Interest in covered bonds appears to be growing strongly worldwide. On the one hand, this is due to the solid performance over more than 200 years: Since the first Pfandbrief was issued, there has not been a single payment default. In addition, against the backdrop of rising home prices, banks are increasingly turning to mortgage-backed bonds. This is especially true for Eastern Europe, but also Southeast Asia.

Unlike during other crises, property prices did not fall during the Corona pandemic either. This has further fueled the market and made cover assets more valuable. "So overall, covered bonds are in a better position at this point in time than they were before the pandemic broke out", Henrik Stille, lead portfolio manager of the Nordea European Covered Bond strategy, explains.

Covered bonds are becoming rarer

Although spreads widened sharply in May 2021, covered bonds performed far better this year than other fixed-income assets such as German Bunds. In addition, spreads have quickly tightened again – most notably in Greece (see chart).

Although more Pfandbriefe were issued in 2021 than in the previous year, overall volumes still declined. This is due to repayments, which have risen steadily since 2018 (cf. Graphic). According to Stille, this development is likely to continue for the foreseeable future.

Tapering likely to favor covered bonds

So covered bonds are likely to be among the winners when central banks move to tapering. Under the Pandemic Emergency Purchase Programme (PEPP), the European Central Bank (ECB) bought government and corporate bonds on a large scale, but hardly any Pfandbriefe. Accordingly, according to Stille, the asset class should hardly be affected when the ECB discontinues the program in March 2022.

"At the same time, the ECB plans to ramp up the Asset Purchase Program, or APP for short, to around 40 trillion euros. Euro per month double. This will fuel demand for covered bonds, which account for around 9-10% of the program", explains silence.

The scaling back of the PEPP program will sharply increase the supply of government bonds, according to calculations by Citi Research, the ECB and Bloomberg – putting the asset class at a further disadvantage to the highly sought-after but rare covered bonds.

Investors would therefore be well advised to switch from government bonds to Pfandbriefe. "However, Pfandbriefe are also a good substitute for investment-grade bonds. This is how higher returns can be achieved with comparable risks", so silence.