The spreads at which small covered bond transactions are getting done in the secondary market say more about the risk appetite of the Eurosystem than where private sector investors will buy.
In other words, trades being executed over the illiquid summer period are not necessarily representative of the real clearing levels for primary, benchmark-sized transactions in covered bonds — which will become all too clear when the market reopens in September after the summer break.
With issuers likely to return to the market in full force in September, it seems probable that spreads will have to return to levels that engage with private sector demand. That dose of reality probably means spreads will have to widen — exactly as happened in the covered market last year.
Nowhere has the squeeze been more conspicuous than in the French covered bond market where a combination of negative net supply and relatively more aggressive purchasing by the Banque de France has caused the sector to trade tighter than German Pfandbriefe, a reversal almost unheard of in the market.
But even leaving France aside, it’s questionable whether the tight spread levels of Italian, Spanish and Portuguese covered bonds can be sustained as the market resumes.
This year, though, the technical factors in the market stack up very differently. The peripheral issuers have been heavy users of the ECB’s Targeted Long Term Refinancing Operation, limiting the total volume of supply.
More broadly, issuers have funded early. In 2015, €82bn in covered bonds had been issued up until August and €62bn followed between September and December. This year, €96bn has already been issued which means issuers are €14bn ahead compared to last year.
So while the market will resume issuance, last year's late supply burst is unlikely to be repeated, and it is more likely the pace of deals will revert back to the average. In the three years to 2014 the average amount issued in euros between September and December was €33bn.
If supply does go down to that level, it will be €10bn less than the expected €43bn of covered bond redemptions that fall due over the rest of this year.
So while some widening is inevitable to draw real demand back in real size, it should just be a small readjustment. A short-lived change rather than the sustained move that was seen throughout the last four months of 2015.
In fact, with half of this year’s remaining redemptions due in October, the market could well be set for another technical squeeze as soon as November.