This week’s Pfandbrief deal issued by Landesbank Hessen-Thueringen was only just subscribed, as the low yield and incredibly tight spread discouraged investors. The transaction followed a string of German and other core European deals which have also floundered because the yields on offer were too low.
Fixed rate real money investors would rather buy higher yielding unsecured or even subordinated debt from well-capitalised and highly-rated European banks. That yearning for yield has been exacerbated by the fall in outright yields this year.
As the coupons offered by Europe’s financial institutions have collapsed in tandem with Bund yields, investors have been driven to move down the capital structure and credit curve which has been particularly detrimental for covered bond demand. Adding to this problem is that market has been shrinking for the last couple of years and is expected to do so again in the next year.
There are now some investors who are now starting to ask whether it is really worth all the expense of keeping a paid up team of specialist staff to monitor their dwindling portfolios of covered bonds.
Asset managers, pension funds and insurance firms that have traditionally bought covered bonds, are increasingly looking to reallocate resources to higher yielding long-term alternative investments such as rental or infrastructure.
At some point the pincer movement of declining issuance and tightening spreads will lead to a corresponding structural contraction in demand, as once these buyers are gone, it will be difficult to win them back.
New buyers
But just as these investors have started to question the market’s long term viability, a new batch of buyers could be tempted to increase their holdings. Chief among these are bank treasuries.
Following a recent announcement on the Danish finance ministry’s website and a leaked document from the European Commission, it would seem that higher rated covered bonds could soon be in line for better regulatory treatment in banks’ liquidity buffers. Under the Basel III liquidity coverage ratio, banks could increase their investment in covered bonds from a maximum 40% with a 15% haircut on the valuation to a maximum 70% with a 7% haircut.
This means a structural increase in demand, but the covered bond market should meet bank treasuries halfway, and tweak the product’s structure to fit their needs.
Bank investors, looking to buy for their liquidity buffers, usually prefer to buy floating rate notes (FRNs) and not the fixed rate deals that covered bond issuers have offered so far.
This is for mainly two reasons: The first is that FRNs attract meaningfully lower haircuts with the European Central Bank, which makes the product’s intrinsic liquidity backstop far more appealing.
The second is that FRNs are typically less volatile. Because of that the cash margin that banks need to hold against their investment, in case of an adverse price movement, should be much lower than for example, a 10 year fixed-rate covered bond.
But so far, floating rate covered bonds have only really had much success in the sterling market. Only UniCredit has issued a benchmark sized floating rate deal in euros this year.
Last week Stadshypotek tested appetite for floating rate euro issuance. Although it was a diminutive €300m, the Swedish deal could herald a new direction for covered bonds, and one that provides a fresh and more sustainable long term investor base for the low yielding covered bonds that highly rated issuers are increasingly struggling to sell.