As we approach the end of 2024, the economic outlook remains uncertain, with debates around whether the global economy is heading for a soft or hard landing. Amidst this uncertainty, one asset class stands out as a beacon of stability and potential performance: Covered Bonds. These instruments, long recognized for their safety and reliability, are poised to outperform European Investment Grade (IG) Corporates and government debt, making them an attractive option for investors seeking both security and returns in a volatile market.
The Enduring Appeal of Covered Bonds
Covered Bonds have a storied history spanning over 200 years, with not a single default recorded in that time. This remarkable track record is a testament to their safety and low-risk profile. As of 2022, the market for Covered Bonds was substantial, with approximately EUR 3 trillion outstanding, primarily issued by countries like Denmark, Germany, France, Spain, and Sweden.12
These bonds are characterized by their “dual-recourse” nature, meaning they are backed by both the issuing institution and a cover pool of assets, such as mortgage loans or public sector debt. This dual backing, coupled with stringent local legislation, low Loan-to-Value (LTV) requirements, and active management of the cover pool, ensures that these bonds remain highly secure. Furthermore, European regulations, particularly under the Bank Recovery and Resolution Directive (BRRD), have exempted Covered Bonds from bail-in procedures, adding another layer of safety for investors.
Market Dynamics in 2024
The first half of 2024 saw a reduction in new Covered Bond issuance, following a record high in 2023. This decline was anticipated, as mortgage activity slowed across Europe. The decreased supply contributed to a tightening of spreads, with Covered Bonds seeing a 13 basis point improvement by the end of May 2024. However, market volatility reared its head in June when French President Emmanuel Macron’s unexpected call for snap elections sent shockwaves through the markets. This uncertainty, coupled with concerns about fiscal policies in countries like France, Italy, and Belgium, led to a widening of spreads in both government and Covered Bonds. Nevertheless, despite this volatility, the inherent safety of Covered Bonds positions them as an attractive entry point for investors, especially when compared to the more volatile IG corporate bonds.
Investment Case: Covered Bonds vs. IG Corporates
The recent widening of spreads in Covered Bonds, contrasted with the tightening spreads in IG Corporates, presents a compelling investment opportunity. Historically, the spread between corporates and Covered Bonds has hovered around 100 basis points, but as of mid-2024, this pick-up has narrowed to approximately 40 basis points. This presents a rare opportunity for investors to enter the Covered Bond market at attractive levels. Looking ahead, we anticipate a continued decline in Covered Bond issuance due to reduced mortgage activity. In contrast, IG corporates, which are currently priced optimistically for a soft landing, may face more significant challenges in a choppy economic environment. Covered Bonds, with their conservative nature, are expected to perform at least in line with corporates, if not better, offering more protection and higher risk-adjusted returns.
Investment Case: Covered Bonds vs. EU Government Bonds
Covered Bonds are often seen as a substitute for EU government debt, given their defensive and high-quality nature. The supply dynamics in 2024 further bolster the case for Covered Bonds. While the net supply of EU government debt is expected to increase due to ongoing budget deficits, the issuance of Covered Bonds is likely to remain subdued. This imbalance in supply supports the performance of Covered Bonds relative to government debt.
In the second half of 2024, we expect Covered Bonds to continue offering solid protection in risk-off environments, with better-expected returns compared to government debt. In our view, active management in this space can further enhance returns, leveraging opportunities in a market where the supply-demand dynamics are favorable.
In conclusion, 2024 presents a potentially unprecedented opportunity to invest in Covered Bonds. As an asset class, they offer an attractive allocation within strategic asset allocation, particularly for risk-averse investors looking to diversify away from corporates. With comparable returns at lower risk levels, we believe Covered Bonds stand out as a compelling choice in the current market environment.
Nordea Asset Management’s (NAM) Value Proposition in Covered Bonds
NAM stands as a leading player in the Covered Bond market, managing around EUR 40 billion in this asset class. With a seasoned team of portfolio managers boasting an average of 20 years of experience, we have consistently demonstrated its ability to generate alpha potential in this space. Unlike passive strategies, our active management approach takes full advantage of the inefficiencies and nuances within the Covered Bond market, such as issuer premiums and rating methodology discrepancies.
With our proven track record and deep expertise in Covered Bonds, NAM is well-positioned to help investors navigate this complex market, seeking to deliver attractive risk-adjusted returns in 2024 and beyond.