Growing mortgage lending, last week's agreement for a new EU Framework and the trend to ‘green up’ finance all support a growth trend.
Covered bonds are a cornerstone of long-term finance as they represent an efficient source of financing of the economy with a high level of certainty for investors.
“Issuers rushed to bring deals to market ahead of the ECB's QE phase-out and the ending of the Covered Bond Purchase Programme 3 (CBPP3) in January 2019. This resulted in the covered bond market to increase in issuance by 19% in 2018, as reported by Bloomberg. With the latest market developments, I expect this positive trend to continue in the medium term”, comments Chiara Caprioli, Business Development Manager at LuxSE.
Covered bonds markets are particularly well developed in Denmark, Germany, France, Italy, Spain and Sweden, as these countries have longstanding national covered bonds regimes in place. Other countries do not even have a local covered bond regime. The lack of EU-wide standardisation has led to a fragmentation of the market. As a result, cross-border distribution has been complicated and has stalled a more dynamic growth of the market. This should soon change.
Levelling the playing field
The EU Parliament has just last week adopted the framework that sets minimum harmonisation requirements for all covered bonds issued in the EU. This will – according to the European Commission – increase security for investors and open up new opportunities, in particular where markets are less developed.
Another element for the positive outlook for covered bonds is the growing mortgage lending. According to Bloomberg, the share of conventional 30-year purchase loans originated with loan-to-value ratios above 90% has increased to 35%, from 5% in 2010. Figures from the European Covered Bond Council (ECBC) show that in aggregate terms the mortgage market in Europe grew by 2.3% in 2017 after having experienced a contraction of around 1.3% in the previous year.
Sustainable finance enters the picture
Another harbinger for a positive outlook is the progressing ‘greening’ trend in finance. Green bonds have been the litmus test of market appetite and proved that the potential is huge and replicable to other financial products. Covered bonds, in particular with their underlying (green) mortgage loans, are on the right track to repeat the green bond success.
Alongside the EU green finance works and ambitions, national regulations and industry organisations are already, and increasingly, recognising this asset class. The development of common EU tagging criteria for “energy-efficient mortgages”, as set out by the EMF-ECBC Energy Efficient Mortgages Initiative, already endorsed by some 40 EU banks, streamline the works towards common product recognition and standardisation.
On the regulatory side, Luxembourg was the first country in the world to pass a law on green covered bonds back in 2018. It allows the use of loans that are secured by rights in assets or securities linked to renewable energy, i.e. energy produced from non-fossil renewable sources, such as wind, solar, thermal, geothermal, hydrothermal and marine energy.
Market infrastructure in support of ESG
Some covered bond issuers choose assets considered to have a positive environmental and/or social impact in the cover pool, mostly green building mortgages, renewable forestry and renewable energy loans. ESG – environmental, social, governance – investors are increasingly pushing for transparency and clarity around the actual impact of the projects they invest in, meaning there is a market push to deliver such information – upfront, on an ongoing basis, and in a comprehensive manner.
“This is why we have decided, back in 2016 to launch a dedicated platform –the Luxembourg Green Exchange– that caters to the needs of ESG-focused investors. We are here to ensure that this still nascent market can flourish around increased transparency and third-party endorsements. Easy analysis and comparison that investors can make via our platform, based on comprehensive and standardised information, should help them make better-informed decisions”, she explains.
According to market experts, for all those banks considering issuing a green-covered bond, the timing could not be better. Strong investor appetite, fueled by the appeal of high protection and green features, the EU Sustainable Finance Action Plan and the successful EMF-ECBC Energy Efficient Mortgages Initiative are all strong signs of the market momentum.
Addressing the risks
The green covered bond market is still small and relatively new but fast-growing and innovative. Some observers raise concerns that in such a burgeoning marketplace, green covered bonds might fall prey to greenwashing. In other words, that proceeds will be misallocated to non-green projects. “I strongly believe that transparency is and will always be the key way to ensure market quality. If investors can easily find information, for example on our platform, deep-dive into the details, and perform solid due diligence, the risk of misinformation is minimal”, she adds.
The EU framework on sustainable finance will also play an important role in curbing any attempts of greenwashing as issuers from different markets will need to abide by common standards of information and disclosure obligations.
After a couple of years of stagnation, economic and regulatory momentum, stable credit quality and sustainable finance developments should push the EU covered bonds market already valued at EUR 2.5 trillion into stable net growth in the short- and medium-terms.
“Covered bonds are an efficient source of financing and a stable instrument for diversifying portfolios. If the EU proves successful in improving the overall product quality without imposing excessive complexities, I am positive that we will observe a stable growth in this asset class”, concludes Chiara Caprioli.
The greening tide that has just started to paint some covered bonds green has a huge potential to extend the safety features of this product.