ECB must buy covered bonds aggressively, or not at all
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ECB must buy covered bonds aggressively, or not at all

The European Central Bank will face a dilemma when it embarks on its third covered bond purchase programme, which will probably start on Wednesday. Either the central bank buys covered bonds aggressively, something that it has vowed not to do, or it will fail to meet its own target for expanding its balance sheet.

The ECB is running out of policy options. Faced with falling eurozone growth and declining inflation the prospect that the central bank will need to embark on unconventional measures is drawing closer by the day. On Tuesday the German ZEW October current conditions sentiment index collapsed and is now at levels last seen in November 2012. Italian and Spanish September inflation is negative and French inflation is quickly getting there.

The ECB has said that it wants to expand its balance sheet to the levels was last seen in 2012 when it peaked at €3tr. As it has fallen to about €2tr, it will need to expand by about €1tr. The ECB recognises that there are about €600bn of covered bonds in its database that are eligible for purchase, but it will be lucky to buy a small fraction of these unless it severely distorts the market.

It will begin by approaching the Street and looking for offers. However, as regulations have encouraged banks to hold about 20% of the trading inventory they had pre-crisis, these bonds will quickly disappear.

The ECB may then hope to buy bonds in the primary market. The trouble is that banks are more likely to be considering capital trades following the asset quality review at the end of October. Meaningful primary covered bond issuance may not get going until next year, if at all.

The central bank says the buying programme will last long enough “to allow beneficial secondary effects to develop,” and hopes tighter spreads will encourage more supply. But spreads are already at precrisis levels and supply still hasn’t picked up.

Cédulas issued by banks like BBVA a decade ago are now actually trading at tighter levels than when they were issued, but the last Spanish deal was issued in June, and only five Cédulas have been issued this year compared to 12 last year. Though it’s possible a few borrowers are waiting for the ECB programme to start buying, the majority simply don’t need the funding, no matter what the spread.

Banks, especially those in the periphery are still deleveraging. UniCredit, for example, aims to reduce its balance sheet by €50bn within the next few years. This lack of demand for funding suggests the ECB's purchase programme will not encourage issuers to sell retained deals to the central bank.

With secondary supply set to be exhausted quickly and the primary market unlikely to deliver, the central bank could soon start to feel the heat. It will then need to try to negotiate bilateral deals with individual note-holders.

But these investors face the same supply problem as the ECB. They will be unable to replace all their covered bonds with new ones, so they will not consider selling unless the price is appreciably higher than the market. Even then, they may prefer to stay invested. But to get noteholders to come to the table, the ECB must aim for a price that’s extremely attractive.

It will probably only take a few weeks before the ECB realises the futility of the covered bond purchase programme, and the risk it runs of destroying the very market that it’s trying to grow. If it continues to move down this ‘insane’ road, investors that hit the ECB's bid may move on to other products. By then, they may be lost to covered bonds.

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