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Draghi breathes new life into 246-year-old mortgage bond market

Mario Draghi's efforts to boost Europe's economy are reviving a 246-year-old bond market that used to provide a vital source of financing to mortgage lenders.

[LONDON] Mario Draghi's efforts to boost Europe's economy are reviving a 246-year-old bond market that used to provide a vital source of financing to mortgage lenders.

The European Central Bank has bought 138 billion euros (S$205.6 billion) of covered bonds, securities backed by assets including home loans, since entering the market in October 2014 as part of its quantitative easing program. That's helped sales this year rise to the highest since 2012, Deutsche Bank AG data show.

The revival has been driven by banks from outside the region, who are flocking to take advantage of borrowing costs pushed down by QE, reversing a dip in issuance prompted by tougher capital regulations on Europe's lenders. Issuance has outpaced redemptions, bucking analyst expectations that the 850 billion-euro market would contract for a third consecutive year.

"The market has been supported by the ECB and issuers have taken advantage of this and issued more than expected," Cristina Costa, a senior covered bond analyst at Societe Generale SA in Paris, said by phone. 

Sales of the notes, at 143 billion euros through Nov 24, have surpassed the 140 billion euros of redemptions scheduled for 2015, according to data compiled by Deutsche Bank that includes bonds issued in the single currency with a notional amount of 500 million euros or more. Redemptions outstripped issuance by 53 billion euros in 2013 and 40 billion euros last year, the data show.

Non-euro area banks have contributed the largest share of total sales since 2011, the Deutsche Bank data show. Canadian issuers led the charge, selling 13 billion euros of bonds with no redemptions this year, according to SocGen data. By contrast, Spanish banks' 19.8 billion euros of sales was dwarfed by 37.5 billion euros of redemptions.

The ECB holds about 25 per cent of euro-denominated benchmark covered bonds sold by euro-area banks, according to SocGen.

"This year's net issuance will be very different from what most people thought at the beginning of the year," said Bernd Volk, head of European covered and agency bond research at Deutsche Bank. "Positive net supply is supported by ECB purchases and is also due to high issuance by banks outside the euro area."

Covered bonds were pioneered in Prussia in 1769, when King Frederick the Great let aristocrats, churches and monasteries raise money by pledging their estates as collateral. The market evolved to become a key source of financing for private housing across Europe.

The securities have historically been attractive to investors because they are guaranteed by the issuer and backed by a pool of assets, such as mortgages and public-sector loans. The notes are also excluded from looming European regulations that will make bondholders share the burden of bank failures by having unsecured debt written off, or bailed-in.

"Investors like the relatively low risk of covered bonds and the fact that they are exempted from bail-in," said ABN Amro Bank NV fixed-income strategist Joost Beaumont in Amsterdam.

While SocGen estimates 2016 redemptions will marginally outstrip sales of euro benchmark covered notes - 149 billion euros versus 145 billion euros - Costa said the market is poised to expand.

"This is the start of a turning point because previously we've had significantly negative net issuance," Ms Costa said. "From 2017 onwards, redemptions will drop off so the covered- bond market could grow again."