Thanks to structural protection, covered bonds offer a higher-yielding alternative to govies

Low spread volatility and a stable supply-demand balance

In addition, covered bonds exhibit low spread volatility even in turbulent times, as was observed once again as recently as March, when, following the outbreak of the Iran crisis, the asset-swap spread of the iBoxx Covered Bond Index remained stable with a price fluctuation of just 5 basis points.

With other bond classes, such as corporate bonds and government bonds, comparatively higher spread volatility is always to be expected over a longer period.

Furthermore, supply and demand—currently the most influential factor—point to a continued stable risk premium for covered bonds.

Positioning and generating additional returns with covered bonds

BayernInvest uses the following strategies to generate additional returns: relative value, duration management, and country allocation.

1. a) Inclusion of government bonds,
2. b) active duration management, and
3. c) a significant overweight in country segments such as emerging markets and Eastern Europe.

Depending on country and yield curve positioning, covered bonds for core countries currently offer 20 to 40 basis points more in yield than the underlying sovereign bond. In the periphery, in my opinion, this applies only up to medium maturities. Government bonds are particularly suitable here for two reasons:

First, depending on the yield outlook, the additional return from the underlying sovereign in the longer-term segment can be incorporated into the management of a longer duration. Currently, we are also leveraging the steepness of the swap curve to maintain a slightly longer duration relative to the benchmark and, where necessary, tactically hedging against the volatile interest rate environment using Bund and Bobl futures.

Second, new issuances of covered bonds from peripheral countries with attractive spreads over core markets have declined significantly in recent years. Much of this decline in supply has been offset over the past few years by growth from third countries and Eastern Europe. Both of these country groups have thus become key components of our positioning. Conclusion here: Depending on the spread forecast, the weighting of both segments in BayernInvest’s positioning has, in retrospect, deviated—in some cases significantly—from the benchmark.

The table in Figure 4 shows, using third countries as an example, that this positioning generated additional returns in the one-year performance.

In the three- and five-year reviews as well, Canada, Australia, New Zealand, and South Korea consistently outperformed the iBoxx Covered Bond average, while Germany slightly underperformed the index. Covered bonds from Eastern Europe exhibit a similar performance pattern within the fund.

Selection based on fundamental analysis of the legal framework, issuer, and country

To ensure the portfolio’s granularity, a wide selection of countries and issuers that regularly issue benchmark bonds is essential. At BayernInvest, a mandatory prerequisite for investing is the existence of a covered bond law in the respective country. The strict principle here is: no law—no investment.

In a second step, the strengths and weaknesses of the law are analyzed. Weaknesses do not immediately lead to a negative decision; rather, they always serve as good points of discussion for BayernInvest, which are addressed in one-on-one meetings with the issuer. This is because every issuer always has the opportunity to improve key aspects of its covered bond program in line with the law. Canadian legislation, for example, has every reason to stand up to comparison with German law.

At BayernInvest, a large portion of the time is devoted to analyzing and monitoring the issuer. To put it simply: If the bank is sound, the coupon and principal payments are secured.

As is well known, covered bonds are specially protected. In the event of the bank’s insolvency, the covered bond creditor has an exclusive right of recourse to the cover pool, meaning that the analysis and monitoring of the cover pool is also an important component of fundamental analysis. This dual right of recourse is the key feature that distinguishes covered bonds from other real estate investments, such as real estate funds and asset-backed securities.

Summary

Covered bonds exhibit low spread volatility even during turbulent market phases while offering structural protection that other asset classes cannot match. In its covered bond fund management, BayernInvest generates additional returns through the active inclusion of government bonds, a clear positioning in country allocation, and active duration management.