Covered bonds are in an excellent position to offer attractive returns in the months ahead, whether the landing is a soft one or not.

By Henrik Stille, Manager of Nordea European Covered Bond Strategies

In over 200 years of existence, covered bonds have never experienced a single default. The reason is that they offer double protection. On the one hand, investors have a claim on the issuing institution, and on the other, covered bonds are protected by a pool of mortgage collateral or public-sector debt. This makes them one of the safest asset classes. Despite this, covered bonds may offer steady, attractive returns.  With a volume in circulation of around 3,000 billion euros, the covered bond market is a very large one. The main issuing countries are Denmark, Germany, France, Spain and Sweden.

While covered bond spreads had already widened in 2022, this trend continued in 2023. In contrast to last year’s sharp contraction in spreads on the credit markets, this development is in line with a generalized risk appetite. The reason for this is the higher-than-expected volume of covered bond issues in 2023 – and not insufficient fundamentals that would have justified such wide spreads.

The yield advantage of corporate bonds over covered bonds has therefore narrowed. Against this backdrop, investors can take advantage of a very attractive entry level for covered bonds.

Lower supply expected

As a general rule, covered bonds perform particularly well in times of economic difficulty. This has been demonstrated in the past. At present, the market is optimistically pricing in a soft landing. But even in this scenario, covered bonds should offer attractive returns¹. Compared to investment-grade corporate bonds, covered bonds should offer higher risk-adjusted returns this year.

Thanks to their highly defensive and safe qualities, covered bonds are often seen as an alternative to European Union public debt. Given the tight fiscal situation in most countries, we can expect a significant net supply of European public debt in 2024. This contrasts sharply with the expected decline in the supply of covered bonds. Overall, the volume of covered bonds available this year is likely to be around 40% lower than in 2023. This is due in particular to lower demand for mortgages against a backdrop of sharply rising interest rates. In addition, European banks have already repaid most of their long-term ECB loans in 2023, which they financed with covered bonds. This year, only small repayments are planned, and eurozone banks have plenty of liquidity. This contrasting trend in supply once again makes covered bonds an attractive investment in the current environment.

Opportunities in Southern and Eastern Europe

Because covered bonds are safe and highly regulated, many investors regard them as a relatively boring and uncomplicated asset class, and generally apply passive allocation or buy-and-hold strategies. But this impression is extremely misleading, as the covered bond market presents many inefficiencies and nuances. It ranges from new issuers paying a premium to attract investors, to rating methodologies that don’t fully capture the business model of certain issuers. An active investment approach can take advantage of these inefficiencies and complexities.

Although the outlook is good for investors in covered bonds, they should adopt a selective approach at regional level. Contrary to popular belief, covered bonds in Southern and Eastern Europe are currently particularly attractive. On the one hand, these regions have attractive fundamentals. On the other hand, banks have little exposure to commercial real estate and are therefore less likely to be affected by the current turbulence in this sector. In Scandinavia and Germany, on the other hand, the collateral pool also includes a lot of commercial real estate. However, investors are not sufficiently compensated for this increased risk.

¹ The value of your investment can go up and down, and you could lose some or all of your invested money.