European covered bonds market

This chapter describes the German mortgage-bonds or Pfandbriefe market, its institutions, and working practice. We also consider other aspects of the European covered bond market. The instruments themselves are essentially plain vanilla bonds, and while they can be analysed in similar ways to US agency bonds and mortgage-backed bonds, there are also key differences between them, which we highlight in this chapter. Mortgage-backed securities are described in Chapter 11. 

The German Pfandbrief and European Covered Bonds Market... 

EXHIBIT7.7 European Covered Bond Market as of 24 January 2003... 

The legislation changes throughout the European covered bond markets, also bring another possibility a step closer—a European Pfandbrief. 

As more European countries aim to establish their own covered bond markets with updated legislation, investors are getting a larger choice of Pfandbrief-like products. Most of the laws are based on the established German framework and aim to provide the same high quality of asset, but slight differences still remain. Here we look at the differences between the main runners in the covered bond arena. 

This new Irish product provides an interesting enhancement to the range of high quality products available in this sector. The legal framework combines all the traditional elements of covered bonds from existing European markets with innovative augmentations that serve to strengthen credit quality further. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

Questions such as the uses to which European bond futures can be put, contract specifications and trading volumes are discussed with illustrative examples. Technical issues, which surround the use of bond futures, are also examined and presented with numerical examples. The issues include the calculation of gross and net basis, identifying the cheapest-to-deliver (CTD) cash market bond, different approaches to measuring relative volatility, calculating hedge ratios, and portfolio duration adjustment. Bloomberg screen output is used to provide a real world flavour to the topics covered. 

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