Nykredit readies senior secured deal as S&P warns on law changes

Nykredit Realkredit announced the mandate for its third euro senior secured benchmark yesterday (Wednesday), which it aims to issue within a “fairly short timeframe”, according to an official at the bank. Meanwhile, S&P has raised some concerns about the implications of a legal change broadening the use of junior covered bonds.

The Danish mortgage bank mandated BNP Paribas, DZ Bank, Nykredit Bank and UniCredit for the euro senior secured bond, and is aiming to issue within a fairly short timeframe, said Morten Bækmand, head of investor relations at Nykredit.

“We have some investor work scheduled for today and tomorrow, and then we will see how the markets go,” he said.

The issuer has in the past primarily referred to the bonds as junior covered bonds, but senior secured bonds is said to be emerging as the market consensus, the designation for which Nykredit has opted this time. The bonds have in the past also been referred to as Section 33e bonds, after the section of legislation that governed them – although this has now changed to Section 15 (see below).

The targeted deal is for refinancing purposes, according to Bækmand.

The issuer expects to issue Eu1bn-Eu2bn of senior secured bonds this year, down from around Eu2.7bn sold last year. This year’s supply will primarily be for refinancing, split across domestic and international issues, although there could be some net new issuance, depending on house price movements.

Danish senior secured debt typically trades close to that of the senior debt of Danish banks, with ING analysts, for example, noting that a Nykredit senior unsecured November 2015 issue has been trading roughly flat to the interpolated junior covered bond curve of Nykredit Realkredit since the end of December.

Standard & Poor’s on Tuesday said that an expansion of how so-called junior covered bonds can be used by Danish mortgage banks following a December legal change could render overcollateralisation of standard covered bonds more volatile and potentially trigger negative rating changes.

The bonds in question are issued out of Danish mortgage banks’ capital centres and are backed by the same cover pool as the standard, or senior covered bonds, but investors’ claim on the collateral in the event of an issuer default is subordinate to that of the senior covered bondholders.

Following an amendment to the legislation in December the bonds are now governed by Section 15 (previously Section 33e), and their permissible use has been broadened. Previously they could only be issued to raise proceeds for the purchase of assets to top up overcollateralisation of CRD-compliant covered bonds (SDOs/SDROs) in the event of house price falls. As a result of the legal change, however, mortgage banks can issue Section 15 bonds for more general OC management purposes, and they can also be issued out of realkreditobligationer (RO) capital centres, which was previously not the case.

Casper Rahbek Andersen, director in S&P’s covered bond team, said that the greater flexibility offered by Section 15 could increase supply of these bonds, and lead to a more liquid market and standardised terms and conditions for an issuer insolvency situation. In the meantime, the amendment to the law does not clarify how timely payment will be made after issuer insolvency, he said, and the market for Section 15 bonds remains fragmented.

Andersen identified two main risks stemming from the broader scope of junior covered bond issuance: potential rating volatility affecting senior covered bonds and the potential creation of two classes of Section 15 bonds.

As concerns the first risk, Andersen noted that the overcollateralisation available for covered bonds partially funded with Section 15 bonds may become more volatile due to their traditionally short maturities, while the cover pool includes loans and bonds that mature after 30 years.

“In our opinion, the emergence of Section 15 bonds requires investors to consider what would happen if the issuer is unable to refinance the Section 15 bonds,” he said. “Although Section 15 bonds boost the available overcollateralisation for the covered bonds, they will need to be refinanced several times before the covered bonds mature.”

An issuer with overcollateralisation of 8% today, for example, with 2% of it funded by Section 15 bonds, may have only 6% in two years’ time if it is unable to refinance or reissue the junior covered bonds, said the analyst.

Fluctuating overcollateralisation could increase rating volatility, according to the rating agency, although it generally expects issuers that can achieve a triple-A covered bond rating to have a sufficiently high issuer rating to be able to re-issue Section 15 bonds.

“In our opinion, the potential refinance risk mainly occurs once the issuer rating falls below investment grade,” said Andersen. “In such a case, the covered bonds would likely no longer be rated AAA.”

According to S&P, assets funded by Section 15 bonds comprise a substantial proportion – on average 42.44% – of the overcollateralisation in the capital centres from which they are issued.

Separately, the emergence of two-tier lending, as practiced by one Danish mortgage bank [Nykredit], could introduce another risk for certain Section 15 bondholders, said Andersen. Under two tier lending loans with an LTV of up to 60% are held in SDO capital centres and loans with an LTV of 60%-80% are held in RO capital centres, with the December amendment allowing Section 15 bonds to be issued out of both types of capital centres.

“This could eventually create first and second tier Section 15 bonds,” said S&P. “Were the borrowers to default, the issuer would need to draw on the highly rated collateral bought as part of the bond issuance, thus reducing the available overcollateralisation for the Section 15 bondholders.”

It said that recoveries will probably be higher in capital centres backed by loans with a lower LTV ratio, and the cover pool administrator is less likely to require overcollateralisation funded by Section 15 bonds in a stress scenario, which could create different risk profiles in terms of recovery for the different tiers of Section 15 bonds. However, S&P noted that it does not make a distinction between the ratings on first and second tier Section 15 bonds.