Credit ratings have provided the transmission mechanism that effectively links the sovereign rating to the covered bond rating. And, as sovereign downgrades have filtered down to covered bond programmes, many issuers based in the periphery of Europe have been shut out of the publicly syndicated covered bond market.
Though UniCredit showed it is possible to sell a covered bond that is rated below the material regulatory rating threshold of AA-, and at funding levels that are much cheaper than its own government, it will be a difficult act to follow.
Thanks to the intervention of the European Central Bank, which flooded the market with its long term refinancing operations at the end of last year and the beginning of this, there has been no major bank insolvency. However, this wave of liquidity has starved cash-rich investors of choice and funnelled their extensive demand into a confined selection of highly rated and generally more liquid covered bonds from issuers residing in core Europe and those outside.
This concentration of demand has caused spreads in these regions to tighten sharply, a situation that has been exacerbated by negative German government bond yields.
But this technical bid is becoming increasingly difficult to justify from a fundamental standpoint and, though a correction is probably overdue, the timing of such an event is almost impossible to predict. Investors have therefore tried wherever possible to diversify away from Europe and the euro.
Participants in this roundtable are:
Florian Eichert, head of covered bond research,
Crédit Agricole CIB
Christian Haller, head of financial institution origination, Crédit Agricole CIB
Vincent Hoarau, head of financial institutions,
covered bond and ABS syndicate,
Crédit Agricole CIB
Daniel James, global markets alpha portfolio management, Aviva Investors
Bence Lanyi, euro credit portfolio manager,
Magyar Nemzeti Bank
Philippe Mongars, deputy director,
Banque de France
Nicolas Poli, head of supra-agencies trading,
Crédit Agricole CIB
Juan Pablo Soriano, director general, Moody’s
Mark Stacey, portfolio manager, BlueBay
Jean-Erik de Zagon, head of portfolio management
division, European Investment Bank
Bill Thornhill, editor, The Cover
EUROWEEK: How has the relationship between the issuer and its sovereign changed over the past year?
Florian Eichert, Crédit Agricole: Sovereign risk determines whether or not an issuer has access to the market at all at this point and this has become more and more obvious in the last year. If you have the European Stability Mechanism injecting capital directly it could be possible to break the sovereign-issuer link, but at this point they’re probably closer than they ever were.
Mark Stacey, BlueBay: We believe the link between sovereigns and bank spreads still exists and until banks are able to be recapitalised by a credible entity off the domestic sovereign’s balance sheet then this link will hold.
EUROWEEK: Has this led to a blurring of division between asset classes?
Jean-Erik de Zagon, European Investment Bank: We used to have very clear asset classes: you had sovereign bonds, covered bonds, corporate bonds, and banks. That has changed because the sovereigns are perceived differently and as individual risks. The risk perceptions of individual sovereigns are affecting the pricing of all the other types of bonds from the same region.
Daniel James, Aviva Investors: The European sovereign crisis has affected a lot of asset classes, rightly or wrongly, by association. There are some high quality corporate borrowers that don’t typically derive their earnings from the peripheral region in which they’re located but they are suffering from contagion. One of the interesting things with covered bonds is that you also have a call on the underlying assets as well as the credit so you’re potentially better insured. But obviously one has to be very conscious of the legal structure of the deal.
Jean-Erik de Zagon, EIB: What is a problem for investors is that covered bonds become correlated to the behaviour of the sovereign and the diversification effect on portfolios can be quite affected.
EUROWEEK: Juan Pablo, do you believe covered bonds risk could ever become de-linked from sovereign risk?
Juan Pablo Soriano, Moody’s: It would be very challenging. There are a number of linkages between sovereign and covered bond ratings but the most challenging one to overcome would be exceeding the local currency ceiling. Covered bonds in jurisdictions with local currency ceilings are unlikely to surpass this ceiling due to the political, economic and legal risks that drive the ceiling.
A country ceiling captures externalities and event risks that unavoidably arise as a consequence of locating a business in a particular country, and which ultimately constrain domestic issuers’ ability to serve their debt obligations.
Christian Haller, Crédit Agricole: The link has become closer than ever over the past 12 months and it looks like this trend will continue. It’s easy to see why the German banks fund at tight levels. If you look at their senior ratings most German issuers are not any better than their peers in other European regions but their covered bond funding is by far the cheapest. This gives you a very clear view on the importance of (a) the country and (b) the legislative framework.
EUROWEEK: Juan, why are peripheral programme ratings so closely correlated to their sovereign?
Soriano, Moody’s: Moody’s has always had local currency ceilings and typically no covered bond rating in a country exceeds these. Until recently the rating ceiling for the eurozone had been triple-A, but this is no longer true because the likelihood of peripheral countries exiting the eurozone or suffering currency redenomination is, although remote, no longer negligible.
EUROWEEK: But it seems ratings are increasingly driven by non-covered bond rating methodology such your swap counterparty methodology. Can you explain why?
Soriano, Moody’s: Our structured finance swap counterparty criteria is not applied to covered bonds as we assume a swap failure following an issuer’s default and have built material losses into our modelling for this risk. The consequence of the failure of swaps following issuer default may not only leave a transaction open to interest and currency risks, but these risks in turn may lead to the acceleration and creation of additional refinancing risk.
EUROWEEK: Can you tell me why refinancing risk is such an important driver of overall risk?
Soriano, Moody’s: For us it is one of the key risks in the analysis of covered bonds. Where covered bonds are issued as bullets, the losses we typically model for refinancing risk are greater than from collateral losses. Moody’s believes the highest covered bond ratings cannot be achieved where there is material refinancing risk, unless the covered bonds are also supported by a highly rated issuer.
EUROWEEK: Where do you see the biggest risks? Presumably Spain, with its real estate problems?
Haller, Crédit Agricole: It is definitely in the periphery where inflation in the real estate markets has been the highest. I don’t like the idea of Spain-bashing but there are risks there. Italy is in a different situation as it has huge private savings.
EUROWEEK: But every bank is different.
De Zagon, EIB: While the periphery markets are generally stressed due to the sovereign situation, it is very important to distinguish between the issuing banks and also understand what kind of collateral is supporting the covered bonds — because there are big differences.
But then you also have to take a view on the sustainability of the legal framework in different jurisdictions, as you don’t want that to change with a retroactive limitation of the investors’ rights. Investors need to be sure the regulator will not detrimentally change the legal framework as that could pose a real risk.
EUROWEEK: Would you call that political risk?
De Zagon, EIB: The potential political risk is a key issue to consider as it could make the covered bond even more correlated with the sovereign than it already is.
EUROWEEK: Do you think peripheral covered bonds can price durably inside their domestic sovereign curve in the primary market?
Vincent Hoarau, Crédit Agricole: Absolutely! UniCredit’s recent long five year OBG is a concrete demonstration. The deal, lead managed by CACIB alongside other bookrunners, was executed right in the middle of the summer lull at an amazing re-offer spread level. This was an extraordinarily quick turnaround and a historical deal for this very strong name from the periphery. At 290bp/295bp over mid-swaps, the guidance was set roughly 100bp inside five year BTPs — making this a truly groundbreaking transaction.
EUROWEEK: Why do you think UniCredit was able to achieve this?
Hoarau, Crédit Agricole: The collateral played a key role. It was backed by prime Italian residential mortgages and the pricing and level of interest showed that the borrower is much better perceived than the sovereign in terms of risk profile. The timing was also decisive, as it was launched in the context of a lack of supply in the secondary market and a much improved market backdrop after ECB President Mario Draghi’s supportive comments earlier in August.
Clearly, there is a decreasing correlation between peripheral sovereign and domestic covered bond spreads when it comes to national champions and bank sponsors like UniCredit. The covered bond squeeze in the secondary market, the level of covered bond redemptions as well as the overall lack of investment alternatives made this deal possible at this level. And, it is important to remember, the ECB set deposit rates to zero ahead of the summer.
More importantly, the number of positive responses and participating accounts were strong evidence of the better mood and risk perception towards big universal banks which have a working business model, even if those banks are coming from countries under pressure. Finally it is important not to forget that the secondary market spreads of strong OBGs were already trading well inside BTPs. In this context such an achievement was not a complete surprise — otherwise we would not have launched the deal and gone public with a spread that was 100bp inside BTPs.
EUROWEEK: Does this mean other issuers will be able to price inside their sovereign?
Hoarau, Crédit Agricole: The question remains whether this type of spread differential will be possible between a top Spanish Cédulas issue and Bonos. Time will tell, but UniCredit has certainly set a precedent paving the way for others.
EUROWEEK: How can you economically justify pricing a deal through its sovereign?
Bence Lanyi, Magyar Nemzeti Bank: We are in the middle of the European sovereign crisis, where peripheral government bonds are hit the hardest and this is where the selling pressure is culminating and contagion takes place. Peripheral covered bonds pricing through government bonds is economically justified by, in many cases, a higher credit rating, less political risk, sound jurisdictions and the value of collateral.
Philippe Mongars, Banque de France: Under normal circumstances covered bonds yields should naturally trade at a premium over government bonds. Though that’s not the case in the periphery where there are sovereign concerns.
EUROWEEK: Are covered bonds viewed as safer bets than government bonds, as there is security and an insolvency procedure?
Stacey, BlueBay: This depends largely on the country and the bank. Various jurisdictions have more or less favourable covered bond laws and one could also argue that the insolvency process has never really been tested for covered bonds so the wind-up process is still a relative unknown.
One also has to look at the individual bank the covered bond has dual recourse to. If it is a well diversified bank with operations in several jurisdictions and a solid pool of assets then in theory these bonds could be safer bets than the domestic government bonds, as the recovery from the cover pool could still be 100% while the government bonds have haircuts.
Lanyi, Magyar Nemzeti Bank: If you are limited by the credit rating and the sovereign has already fallen out of your universe, you might still be able to buy the covered bonds in a given country. On a primary market issue, it’s more difficult to justify than if you bought in the secondary.
But if the covered bond is backed by good quality prime mortgages to a strong metropolitan area, the quality could be better than the government debt where there may be political risk and high debt.
Sovereigns are not risk-free anymore. Though governments have the ability to tax their population, I wouldn’t say it’s necessarily a safer asset class. But with covered bonds you have collateral security, a strict regulatory environment and a sound rating methodology.
EUROWEEK: Methodologies are sound but not always predicable. Moody’s recently overruled its TPI framework when it downgraded some Spanish Cédulas to A3 when in theory the bonds should have gone to Baa2. Juan, can you tell me why that was?
Soriano, Moody’s: Our methodology allows for some flexibility in the application of TPI framework to sub-investment grade issuers. Spanish programmes have several particular strengths — such as an exceptional level of collateral supporting certain programmes. This flexibility allows us to adjust TPI caps case-by-case.
EUROWEEK: Do ratings become less predictable the lower they are?
Soriano, Moody’s: Many parties with whom we have discussed our TPI framework welcome the flexibility of our approach, and given the increased number of issuers now rated Ba1 or below we have recently provided more transparency on aspects of our TPI analysis that apply mainly to these issuers. For these issuers we have added rating bands to the TPI table to clarify the range of likely rating outcomes.
EUROWEEK: You also give credit to voluntary over-collateralisation (OC) as opposed to concentrating on contractually committed OC, why is that?
Soriano, Moody’s: We have always given limited credit to uncommitted OC with issuers rated below single-A. Consistent with evidence from the crisis it’s probable that there will at least be some uncommitted OC in the event of an issuer’s default and we may give this limited value.
EUROWEEK: To what extent has there been a shift into core markets and into covered bonds?
Nicolas Poli, Crédit Agricole: Spread dislocation between core and non-core covered bonds has been exacerbated and, as liquidity and ratings have become an investment constraint, many accounts have increased their core holdings and reduced their peripheral exposure to a minimum.
Mongars, Banque de France: In answering that I will have to wear two hats — as an asset manager and a central banker. Our total covered holdings have increased because of the two covered bond purchase programmes. But what we have done on the non-monetary policy side has not changed very dramatically, even though some issuers have become ineligible.
Stacey, BlueBay: Core markets and covered bonds within them represent the risk-free type of assets that offer the ever-diminishing extra yield that investors are searching for.
Lanyi, Magyar Nemzeti Bank: The relative weight of our covered bond holdings has increased in the credit portfolio. But we have to carefully select issues of good value, as most Pfandbriefe and Scandinavian covered bonds are already expensive.
Our strategy allows us to take exposure to higher beta credits in the short end while in the mid-part of the curve we hold some UK and French covered bonds and in the long end we are more focused on the very best quality names and jurisdictions.
De Zagon, EIB: We aim to preserve the capital of the bank and the investments we do in the treasury are there to support the liquidity of the bank. It is then up to the treasury to decide how to apply those principals.
Poli, Crédit Agricole: As we see it, investors are mainly concerned with liquidity and ratings and many have shifted their investments into liquid core European government bonds, SSAs and core covered bonds because these markets have been less affected by downgrades and less constrained by liquidity.
EUROWEEK: We recently saw National Australia Bank price a 10 year senior unsecured 16bp wider than where Commonwealth Bank of Australia did a 10 year covered bond three months earlier. What does this tell us?
Haller, Crédit Agricole: Liquidity with real money accounts has risen constantly since the beginning of the year. At the same time the investment horizon for typical high grade investors has shrunk dramatically. Many investors can’t buy any peripheral Europe anymore and supply from ‘safe haven issuers’ has decreased.
James, Aviva Investors: We became more conscious of covered bonds a few years ago in the aggregate space. The product increases our investment opportunity set and helps us to identify different areas of value within Europe’s capital structures.
If you’re looking at senior and bank bonds versus covered bonds there are valuation arguments to be overweight in one and short the other.
EUROWEEK: Florian can you tell me a little about the overall pattern of demand this year?
Eichert, Crédit Agricole: Demand is concentrated to a handful of sectors that are already expensive. On the other hand it’s creating a massive issue for Spain, Italy, Ireland and Portugal which are now so low rated most people are not permitted to buy them. Those that can buy tend to be more opportunistic and their aggregate demand is much smaller.
EUROWEEK: How has this need for safety affected yields?
Stacey, BlueBay: It has been a prolonged low interest rate and low growth environment which creates the perfect conditions for credit to outperform. If you look at the European Iboxx Investment Grade index new highs are being made and year to date it has returned over 8.2%.
This just highlights investors’ need for safe assets that provide incremental yield. The ECB’s decision to cut the deposit rate to 0% in July is another example of this technical situation and has exacerbated the hunt for fixed income yield. Perhaps the new risk-free assets are non-cyclical, well diversified corporates with solid balance sheets.
EUROWEEK: To what extent are these moves into the core sustainable?
De Zagon, EIB: There’s a risk of a price correction later on. If and when markets stabilise, tightly priced, low yielding bonds will carry mark-to-market risk. I don’t think it’s sensible to only buy core because of this mark-to-market risk.
Hoarau, Crédit Agricole: The spread gap between core and non-core regions is getting bigger and a correction should occur. Consistent with the cheap LTRO support, some short dated covered bonds in German and Nordic names have been offered inside swaps.
EUROWEEK: But now the core has become so expensive shouldn’t that mean demand goes down the credit curve?
James, Aviva Investors: We are also concerned about how rich certain core markets are trading from a valuation perspective. We have now started to see core interest widen to soft-core jurisdictions like France, Austria and Belgium in an effort to diversify. This is particularly the case where we got to negative yields at the short end of the curve.
EUROWEEK: What are the risks of investing too heavily in the core?
De Zagon, EIB: If we put all our eggs in the same core basket we’re going to have a high correlation. And with the spreads and yield we have today that’s a risk. You probably have a good chance of getting your money back, but you are taking mark-to-market risks. We have been looking to the Nordic market for the last year as it is less correlated with the core eurozone and for that reason it’s a good risk diversification tool.
EUROWEEK: What is driving people to buy bonds with these absurdly low yields?
Stacey, BlueBay: With interest rates at historical lows you can see how this could cause dislocations amongst different asset classes. Take the schatz for example. I’m not suggesting this is a bubble but the fear of capital erosion and the tail risk, in terms of a redenomination of currency in a euro break-up, means that some investors are willing to receive a negative yield on this two year paper, essentially guaranteeing that they receive less than their principal investment. They are paying for the optionality of a euro break-up and receiving Deutschmarks as opposed to another legacy European currency in another asset that they could own at what seems like a higher yield.
EUROWEEK: But even if the peripheral sovereign situation is resolved, presumably it will not necessarily immediately open the funding window for affected banks?
Mongars, Banque de France: This idea of having to invest up to six months or one year with a negative return, having less principal in the end than you had in the first place, that’s not economically rational.
But then again, some people stopped purchasing Italian and Spanish covered bonds regardless of what efforts were being made or the quality of the underlying assets, simply because the rating of the country dropped below a level beyond which you are not allowed to invest. So the impact of rating downgrades and the degree to which you embed those ratings into investment criteria will also have a bearing on the way the market recovers.
You could argue that, even if things were resolved, it will take time before countries’ ratings are upgraded. So there could be a situation where the stress has been removed but there is still little appetite because the ratings are still so low in comparison with investment guidelines.
EUROWEEK: But, as unsustainable as it seems, the situation does not look like it’s about to change does it?
Haller, Crédit Agricole: The core seems expensive but I have had this view for some time — yet spreads have continued to tighten dramatically. We will see how long this situation continues. Once the eurozone crisis is solved this trend is likely to reverse. But who knows if and when the European situation will be solved? As long as it remains unclear, this trend will probably continue.
EUROWEEK: Surely there are some opportunities for funds to take advantage of value in some of the unloved markets?
Poli, Crédit Agricole: Several distressed funds have been looking for opportunities during the crisis even in covered bonds. Most of them have taken advantage of real money accounts cutting Irish covered bond exposure because of their rating constraints. Large turnover happened when bonds were trading in the 60% region, which seemed to be a good recovery level in case of default. We’ve also seen similar flows and interest in multi-Cédulas.
Eichert, Crédit Agricole: You could see potential for more high yield funds to start investing in these assets, and given wider spreads there is probably a better risk-reward over the long run. But on the other hand, there’s still a lot of mark-to-market volatility and uncertainty holding things back.
EUROWEEK: And the fear of a break-up of the euro?
Eichert, Crédit Agricole: Investors are definitely concerned about this. More and more people are asking me questions on the law that the securities are based on and how likely it is that they will get repaid in euros.
EUROWEEK: Have the two LTROs played a role in intensifying the squeeze in core countries?
Stacey Bluebay: The LTROs provided the banks with the liquidity backstop that they needed and removed this tail risk from the market. It intensified the squeeze in core countries in two ways. Firstly it provided cheap funding so reduced the amount of wholesale supply of bonds into the market, which drove spreads tighter. Secondly, banks’ treasuries had excess liquidity, which they wanted to invest in safe credits but still improve their net interest margins.
EUROWEEK: But it is not all good news in terms of publicly syndicated issuance is it?
Haller, Crédit Agricole: On the one hand, the LTROs clearly had positive effects for the issuers, but on the other issuers decided to use collateral for the LTRO instead of public covered bond funding and this has reduced market volumes and liquidity.
EUROWEEK: What has been the effect on the secondary market?
Hoarau, Crédit Agricole: The spill-over effect in the secondary market has made offers in strong and safe names disappear, while traders are very reluctant to go short.
Everything three years and shorter was vacuumed up and the credit curve steepened. In the end the LTRO dynamic affected all the points of the credit curve. More recently the ECB lowered its deposit rate to zero, which further increased needs for alternative safe investments.
All the recent emergency liquidity measures put in place by central banks have reduced euro issuers’ wholesale funding needs. On a gross basis, the two LTROs injected roughly €1tr. Everyone participated, even though peripheral issuers took the lion’s share. In the meantime, everyone front-loaded issuance to advance their funding programmes and now supply from good covered bond names is rare.
EUROWEEK: But the main beneficiaries were peripheral issuers.
De Zagon, EIB: Any bonds paying a higher yield than the LTRO funding level were looked at and this will have included peripheral bonds. So, in this respect, the LTRO clearly helped improve liquidity for the peripheral covered bond markets.
EUROWEEK: Would it be fair to say the LTROs have exacerbated the squeeze in core markets?
Hoarau, Crédit Agricole: Liquidity buffers required by regulators have increased buying flows in safe names and clearly covered bonds benefitted. So unless markets capitulate everything is in place for a proper squeeze in core covered bonds. The spread gap between core and non-core regions is getting bigger and bigger.
A correction might take place given that, at the front end, some German and Nordic names are offered inside swap rates in covered format.
EUROWEEK: We didn’t get much reaction after the first LTRO and the markets were slow to rally after the second. Do you get the impression the rally caught people by surprise?
James, Aviva Investors: The LTROs facilitated the issuance of covered bonds, but bonds were quickly taken down and locked away, which again potentially poses issues for benchmark investors. To some extent the risk rally that the LTRO generated caught people off guard.
Poli, Crédit Agricole: Both LTROs have increased the amount of cash available in the financial markets, and this is pushing investors to put money at work. Core country ratings have remained stable during the crisis and demand is still growing, which is leading to a market squeeze.
EUROWEEK: Did the LTROs increase the sovereign issuer link?
Lanyi, Magyar Nemzeti Bank: The effect of the two LTROs was controversial, but positive. It has definitely improved the banks’ liquidity situation, and also supported their domestic sovereign bond market. But those banks who spent the ECB money on government bond purchases have suffered mark-to-market losses.
EUROWEEK: Is there a risk that a third LTRO would increase the link even further?
Lanyi, Magyar Nemzeti Bank: The market reaction of the LTRO was also positive, credit spreads narrowed in. But if a third LTRO were exercised, it would have a less positive effect, as it would put a further burden on issuers’ balance sheets, which has a systemic risk.
EUROWEEK: Despite these potentially devastating side-effects, do you not think that a third LTRO might still be necessary?
Hoarau, Crédit Agricole: The first two LTROs bought us some time, which was exactly what was needed. But one could argue these operations are like giving drugs to an addict —however I’m not sure we have a better alternative. The excesses of a generation have to be corrected and reforms need to be implemented.
The LTROs certainly don’t address systemic issues, but they provided a timeframe for European leaders to tackle the real problems. In the end, if the ultimate problem is how to avoid bank runs, then we need to ensure confidence in the financial system’s sustainability.
EUROWEEK: Do you think there should be another LTRO?
Haller, Crédit Agricole: As long as the European crisis isn’t solved, the only way for some banks, especially in the peripheral countries, to get liquidity will be with the ECB. So yes, I believe the LTRO will continue either in the current format or another.
Eichert, Crédit Agricole: Maybe not until a year before this one ends. Banks that have borrowed under the LTRO have an exit option after every year, so it’s likely you would have to time a new LTRO to one of those dates. The bigger challenge for many banks is, however, not additional liquidity but to maintain the current level of it. So essentially they don’t have a liquidity problem but a collateral problem.
EUROWEEK: It’s clear there has been an overwhelming move into a few select core names and credits that are not correlated with the euro, but could you ever justify the risk return for holding a peripheral covered bond at this point?
Stacey, BlueBay: It is possible to justify holdings of OBGs or Cédulas. If we were happy with the fundamentals of the credit and the ultimate recovery of the pool, and the technicals didn’t point to any forced selling (as a result of downgrades to HY for example), and the valuations on the bonds offered a pick-up to the sovereign to make up for the liquidity premium needed then a holding would be justified.
EUROWEEK: Holding a peripheral covered bond may make sense in theory but does it make sense in practice?
James, Aviva Investors: You can always justify the risk return in theory. The issue for benchmark investors is that, depending on the size of the issue the cost of not owning a bond relative to the benchmark could be significant. Therefore an investor may well be forced to replicate the index in a slightly different way, or to go up in quality within that geography and try and immunise that tracking error.
EUROWEEK: Has the amount you can invest in non-triple-A rated bonds changed?
Mongars, Banque de France: We have a framework which is divided between investments in the triple-A world and the non-triple-A world. When a bond falls from one category to the other, we are faced with a migration of an issuer from one bucket to the other. Mechanically, everything else being equal, this may mean that for the issuer in question the investible limit becomes smaller because the bucket was already populated.
EUROWEEK: So that means peripheral exposure has to be cut, right?
Lanyi, Magyar Nemzeti Bank: As a central bank we have to follow strict risk guidelines. We have reduced all our European peripheral exposure due to rating downgrades.
James, Aviva Investors: As an investment decision we’re cautious on the periphery. Where you have to have an exposure because of the underlying benchmark we favour the larger, higher quality names. It’s also a function of the underlying legal structure.
EUROWEEK: But if you were to consider investing in a peripheral market what factors would you need to take into consideration?
James, Aviva Investors: Where one doesn’t have an underlying benchmark the decision is made on a valuation basis. Part of that is driven by the technical and macro-fundamentals in that specific jurisdiction. Then you go back to the issue of liquidity. You might have the best investment idea in the world but if it costs you a lot to get in and a lot to get out, it can look like a poor quality trade. So you really must factor in all these issues into any decision.
EUROWEEK: Has a formal decision been made at the EIB on prospective peripheral investments?
De Zagon, EIB: There has been no formal decision taken by our management committee on peripheral countries which are also our shareholders. It’s very much up to us what kind of risk we want to take. Concerning Cédulas and OBGs, it depends on the risk appetite and your expertise. You have to dig down deep to understand investment details before making generalisations. For example, I don’t think the real estate market is the same in Spain as in Portugal.
EUROWEEK: But the bottom line is that these bonds are teetering on junk, at which point the crisis would turn to catastrophe — right?
Poli, Crédit Agricole: Some Cédulas ratings are only one notch away from junk, at which point many investors would become forced sellers. In general investors prefer Italian covered bonds as the banks are less leveraged and the collateral has fewer non-performing loans. In Spain investors are overweight Santander and BBVA.
EUROWEEK: Even if you have the willingness to invest, can liquidity be problematic?
Lanyi, Magyar Nemzeti Bank: It has definitely changed in covered bonds in terms of the wider bid-ask spreads and time needed to transact a larger size. The typical transaction size has also decreased which is not more than €5m versus €10m-€15m a few years ago.
And if you want to sell a €50m clip then you need to find the exact buyer.
Banks are very careful in deploying their balance sheets, especially into the quarter end period. It is really a client and order-based market.
James, Aviva Investors: When you’re talking about an active allocation trade or a specific alpha decision, one always has to factor in liquidity. Even in markets such as Sweden there are not insignificant bid-offer costs to getting in and out of trades.
EUROWEEK: With banks less willing to deploy their balance sheets and many investors holding bonds to maturity, is liquidity increasingly constrained across the board?
James, Aviva Investors: There’s clearly a yield grab going on across the board and one could argue that it is manifesting itself as a large carry trade which one has to be very careful about. One issue affecting liquidity in specific bonds is that some investors are buy and hold, so when they take down paper it gets locked away and you never see it again. But also investment banks are less able to take inventory on their balance sheet this also has the potential to affect liquidity.
Poli, Crédit Agricole: Liquidity has been hurt by confidence first but the covered bond purchase programmes and LTROs have cleared the free float of bonds available leading to a technical squeeze — as most bonds are now stuck with the ECB. As a result, financing and repo costs have risen, forcing banks to reduce their balance sheets.
Hoarau, Crédit Agricole: Liquidity really sits with investors who have a lot of cash to put to work. Benchmark redemptions stand at around €100bn, so the disequilibrium between demand and supply is enormous. The two LTROs have also exacerbated this trend. The ECB’s second purchase programme is still up and running, but behind schedule. Added to that in 2012, there’s been a wall of senior unsecured redemptions refinanced mainly through ECB repo tenders out to three years — of €380bn, of which €195bn are in benchmark format. There’s also around €80bn in government guaranteed redemptions. Those are a big numbers.
James, Aviva Investors: People have become much more aware of liquidity over the last year or two, because it now drives a lot of the profit and loss considerations in your investment decisions. And it’s never static; liquidity changes over time as you can often have events that aren’t specifically related to covered bonds potentially affect liquidity in that market. So again, you have to be conscious of all these extraneous factors when you’re monitoring your active positions as well as when you’re deciding to put on and take off risk positions.
Hoarau, Crédit Agricole: For the time being the market remains sensitive to negative peripheral headlines and rating agency downgrades. Nevertheless, the liquidity situation and the overall lack of supply at the beginning of the summer break has supported a squeeze in low beta names from the strongest jurisdictions.
The ECB rate cut and 0% deposit rate were also strongly supportive, as well as the announcement of buyback programmes. In addition to that, right in the middle of the summer lull, Draghi gave markets confidence that the ECB can take away bigger risks if Spain and Italy get into trouble. This exacerbated the summer rally and the demand-supply disequilibrium.
EUROWEEK: Access to liquidity seems to be an ever more important topic and regulators are trying to hardwire this into the banking system via the Liquidity Coverage Ratio (LCR). Florian, how is that developing?
Eichert, Crédit Agricole: The European Banking Authority (EBA) is trying to collect data that they can use as the basis for their technical standards. It is, however, very difficult to find meaningful data on day-to-day liquidity as the majority of trading is done over the phone and this cannot be as easily tracked as trading on electronic trading platforms. To base a final LCR standard on liquidity in good times when the LCR is designed to provide liquid assets in a very stressed environment is questionable.
In any case the LCR definition will have to go through the European parliament — so there will be a political dimension to the final decision. So, even if there is data to back up liquidity standards, politicians from countries that are negatively affected are less likely to agree to an exclusion of their market from the liquidity buffer.
EUROWEEK: How has the Banque de France’s view on liquidity changed during the crisis?
Mongars, Banque de France: Liquidity is an important element when we decide to invest in certain assets; it also plays a key role. The underlying liquidity of the asset that we accept as collateral is very important. The intrinsic liquidity value of an asset class has had a consequence on our appetite to continue to accept it as collateral.
The question with collateral is: are we going to be able to liquidate the assets in case the counterparty defaults? We collectively have had to deal with past experiences of default when we had to liquidate in a matter of days. Under certain circumstances, that can mean that there is a large amount of positions on assets that proved more or less liquid. This means that one can end up having to hold some of those assets for a period of time. Therefore, when we look at the collateral we accept, we tend to have a narrow view since we want to be able to liquidate those positions in case of need or default.
EUROWEEK: What is your approach to working a specific order?
Lanyi, Magyar Nemzeti Bank: You need to know which counterparty is best serving that market segment and talking to the right client. For example, if you are looking to sell an Italian covered bond, it makes sense to communicate with an Italian counterparty, which might be expected to have broader domestic client base.
EUROWEEK: Liquidity is also affected by deal size, which seems to have shrunk lately. In the quarter to the end of July half the 25 publicly distributed covered bonds were sized at €500m. The size of this sub-jumbo market justified its inclusion in the iBoxx index and presumably it is better to have a well placed €500m than a struggling €1bn jumbo deal. What’s your view on €500m deals?
De Zagon, EIB: Liquidity is important for us and larger deals are generally preferred but if the €500m deal has a spread pick-up and offers diversification — then why not invest?
Lanyi, Magyar Nemzeti Bank: For liquidity purposes we like to focus on benchmark issues, both in primary and secondary markets. I’m aware that the market now considers €500m to be a benchmark issue size, but we have a slight preference towards €1bn+ deal sizes.
Mongars, Banque de France: €500m is fine, it’s a reasonable size for a small issuer or investor, so I don’t have an issue with the size.
EUROWEEK: How do you account for liquidity in your asset allocations?
Lanyi, Magyar Nemzeti Bank: Our top investment priority as a central bank is safety or security, the second is liquidity, and only the third is yield. We run a high grade credit portfolio to enhance yield on the reserves and in this context we sacrifice liquidity for yield. For example, as part of this portfolio, we invest into certificate of deposits, that has practically no secondary market liquidity but the extra yield does compensate.
Mongars, Banque de France: Liquidity is a very important factor but varies depending on whether we have the same degree of urgency in terms of how fast we may need to unwind an investment. Certain assets are held to maturity, these investments are, by nature, held for a long period of time and are not held with a view to liquidating them for liquidity generation purposes.
De Zagon, EIB: Liquidity has clearly changed and we have seen that with the sovereigns and covered bonds. My portfolios are medium to long-term and form a kind of second line of liquidity for the bank. The first line of liquidity is pure cash. We also have a repo line with the Eurosystem so it’s important for us that at least a major part of the bonds in the portfolio can be used for repo purposes with the central bank and bilaterally with other counterparties.
We have liquidity buffers defined by our management committee so a percentage of the treasury’s funds have to go into very liquid assets where some covered bonds could have a role.
Stacey, BlueBay: An input that has changed considerably within the technical analysis is the liquidity premium which needs to be priced into different assets. Most credit asset managers offer daily liquidity in their funds and with the increased regulation on investment banks and their reduction in balance sheet, and consequently tolerance for risk, the premium for holding a more illiquid asset has risen sharply. It has also led to asset managers holding much higher cash balances so they have a buffer in the event of any redemptions.
EUROWEEK: What are your criteria for allocating funds across different covered bond jurisdictions within the eurozone?
Stacey, BlueBay: Our investment process has not changed. We have always invested on the basis of fundamental analysis, technical analysis and valuations. Some of the criteria have changed as the crisis has evolved though. We took the view at the beginning of 2010 that, to be able to trade European credit, we needed to have a view on European sovereigns.
We increased the team with additional sovereign specialists and the yield of the domestic sovereign debt became a key input into the valuation analysis of any corporate credit. Spreads of certain credits could look very attractive versus German Bunds but were a very different prospect when compared to the domestic government bond, either at the present yield or where we anticipated the respective domestic government bond to yield to trade in the near term.
Mongars, Banque de France: We don’t communicate our criteria for our asset allocation but I can tell you something about our principles. First, we try to be not solely dependent on rating agencies’ views on the sovereign issuers. When we make allocation decisions, we take a number of factors into account which affect the Banque de France’s balance sheet over time.
This is quite complex, and there is room for misinterpretation by market participants because we act as both a fund manager and central bank. Often they can find it difficult to distinguish between both functions. But the primary goal when we invest for our reserves is to preserve capital. We are managing the wealth of the country so the idea of making big returns at the expense of a large risk is not something we like.
Lanyi, Magyar Nemzeti Bank: On the one hand the number of eligible issuers has been decreasing in our investment universe, but on the other the number of new issuers has picked up, not just in terms of new jurisdictions but also because smaller names are entering the market from existing jurisdictions.
We try to reach as many jurisdictions as we can. We have tenor-based CDS limits for sovereigns, credit rating limits as well tenor-based rating limits. If an issuer’s CDS is above a certain level then we can only buy short tenors but the lower the CDS the longer we can go.
We were happy to see new jurisdictions joining the covered bond universe such as Australia as it provides a good diversification away from the eurozone from an investor perspective. The inaugural deals from Australia provided a nice pick-up and they have performed well.
During the last 12 months we have started two new currency portfolios besides our existing euro and US dollar assets. Therefore the stake of euro assets has decreased.
EUROWEEK: To what extent are regulations taken into account in asset allocation?
Stacey, BlueBay: An important result of the crisis has been the favour in which regulators have looked at covered bonds. Regulators have acknowledged that this is a crucial funding tool which has been used for hundreds of years within Europe and as such are an asset and tool which need to be protected. CRD IV and Solvency II are good examples of this preferential treatment.
Lanyi, Magyar Nemzeti Bank: Regulatory changes have had an indirect effect on our investment decisions via the perceived liquidity embedded in the market and through the changes of credit rating. I expect the covered bond market to further gain traction, as investors are shifting capital from the sovereign space to the covered universe. This is also a consequence of the regulatory environment and the fact that there has been no default during the 200 year existence of the European covered bond market.
EUROWEEK: Regulation is presumably an intrinsic element for insurance companies.
James, Aviva Investors: If you’re an insurance company then obviously Solvency II forms part of the underlying mandate. So regulation is very important to specific individual mandates, and when you’re formulating an investment strategy you have to be aware of the regulatory issues and the effect that that regulation has on the demand. You need to know who will be the natural buyer of that product.
Stacey, BlueBay: The demand and supply dynamics of other investors and sell side traders forms part of the technical analysis we perform in our investment process. While it is only one part of our process and is secondary to the fundamental analysis it still is important.
Mongars, Banque de France: As a central bank we’re not subject to external regulations, such as CRD IV and Solvency. But since we’re also the one making regulations for banks, we are not completely at odds with the principles of them. Regulation has two potentially supportive effects for covered bonds; first is that they are recognised as eligible under the Liquidity Coverage Ratio and the second is that they are excluded from bank resolution regimes.
James, Aviva Investors: Regulation has to be at the forefront of an investment decision because it drives liquidity. Liquidity is a very broad word and it’s incredibly difficult to measure and invariably it’s a more qualitative than quantitative assessment. Regulatory change is part of that process of qualitative evaluation.
De Zagon, EIB: We are a supranational so we are subject to Basel III on a voluntary basis. It does play a role in helping to determine our liquidity buffer. As such the liquidity ratios by Basel III are very important for us.
EUROWEEK: Does that mean you won’t invest below Aa3?
De Zagon, EIB: Lower rated bonds could present an opportunity provided they give us a bit of mark-to-market stability as diversification.
EUROWEEK: What is the biggest regulatory challenge for covered bonds?
Eichert, Crédit Agricole: One of the biggest challenges relates to the discussion around encumbrance. Issuance of structured covered bonds backed by non-vanilla collateral will give ammunition to people advocating a hard cap on encumbrance which could destroy some business models.
EUROWEEK: Are covered bonds unfairly blamed for encumbering a bank’s balance sheet?
Mongars, Banque de France: Encumbrance is a very important but complex issue. The first thing we have to bear in mind is that we need to come up with an adequate measure of encumbrance. The lack of harmonised disclosure by banks across the world is making it very difficult to measure. I have not been able to find any research that comes up with a proper harmonised measure across various institutions.
Too often, people focus on encumbrance due to covered bond issuance but derivatives placed in bilateral transactions also encumber assets.
It’s important to come up with a proper measurement because we know that encumbrance is going to increase. Regulation, especially on derivatives, will create more demand for collateral. So it’s to be expected that asset encumbrance will get monitored more closely.
The asset side of the balance sheet should play a role in repaying an institution’s unsecured debtors in case of default or bail-in. We have already taken a lot of public money to bail out banks, so it’s in the interests of the general public that there are some assets that remain unencumbered on the balance sheet, and also to protect those investors who are willing to continue buying unsecured bank bonds.
EUROWEEK: Transparency on holistic levels of encumbrance is lacking, but what about transparency in general?
De Zagon, EIB: Regulations should aim to stabilise the financial system but what’s very important is transparency. This is really what we need. By that I mean transparency on the collateral, the business model of the issuer and the legal framework. It is especially important to understand what is in the pool and how stable that is.
EUROWEEK: How have covered bonds benefited from proposed bank resolution regimes?
Eichert, Crédit Agricole: It has benefited covered bonds and taken interest away from senior unsecured as investors know covered bonds are going to be secure. Only the best names from the most desirable regions have been able to issue senior because investors have more confidence that they won’t be bailed in. Tier one peripheral borrowers have also issued senior as the maturities have been shorter than the ECB’s three year LTROs and partly because they attract domestic interest.
EUROWEEK: How does the Capital Requirement Directive IV and Solvency II affect covered bonds regarding rating thresholds and capital requirements?
Eichert, Crédit Agricole: These regulations are reinforcing the importance of ratings and the trigger between AA minus and A plus. Demand is being channelled into core, Northern European, and ex-eurozone issuers such as those from Australia, New Zealand, Canada and Switzerland.
EUROWEEK: Are covered bonds over-favoured by regulators?
Haller Crédit Agricole: I don’t see covered bonds as over-favoured. Maybe the govvies are treated too positively and the ABS market too negatively. In this context the treatment of covered bonds is adequate.
EUROWEEK: How will the secure/unsecure mix vary between higher and lower rated institutions?
Eichert, Crédit Agricole: Higher rated institutions will have senior access while lower rated borrowers are likely to rely more on covered bonds. However, even lower rated borrowers will need to ensure they get a specific portion of bail-in-able debt on their liability side, so some might be forced to issue at high spreads just get the limits built. It’s conceivable that some banks will have to be forced to just issue at any price they can, not for economic reasons, but just to get the ratio at the correct level.
EUROWEEK: Do covered bonds need a healthy senior market?
Haller, Crédit Agricole: Covered bonds need a senior market for sure. Not only is the over-collateralisation funded via senior but there is also a time gap between the point when an asset is financed and the point when it is transferred to the cover pool. Moreover, if we talk about asset encumbrance we need to have a healthy senior bond market.
EUROWEEK: What are your thoughts about asset encumbrance, does a one-size-fits-all cap necessarily make sense?
Eichert, Crédit Agricole: You can’t really impose a particular encumbrance limit as this risks driving up systemic risk. If banks are running into trouble their last option is to get repo funding from the central bank, which increases encumbrance. But you wouldn’t want to cut off this funding just at the most critical point they need it and push all banks off the cliff at the same time.
In any case, each bank will be different. A critical component is the specific level of capital a bank has; the higher that is the more asset encumbrance can be tolerated. But it’s also dependent on what sort of assets are left unencumbered. If they’re higher quality then a bank can get away with greater encumbrance.
EUROWEEK: So banks will need to take more writedowns and raise more capital?
Haller Crédit Agricole: Yes, many banks will need to raise more capital but it is expensive and in some cases even impossible to raise. So this could lead to more consolidation in the banking sector or new creations of run down agencies.
Mongars, Banque de France: This is why we should always have, where possible, impact studies of the possible unintended consequences of regulations. And perhaps there are things that have been done in certain countries that other countries will also implement, in terms of capping encumbrance. That’s not something we have done much in Europe but some countries do have covered bond issuance caps.
EUROWEEK: You can’t have a one-size-fits-all approach as every bank is different, every jurisdiction is different and so on.
Mongars, Banque de France: But the driving principle is that there should be some assets left unencumbered on the asset side of the balance sheet, to cater for a possible default, and therefore, a protection of the unsecured bondholders, regardless of the way your balance sheet is created, regardless of the business model you have as a bank.
EUROWEEK: Nevertheless, regulators and rating agencies will start to sit up and take notice when a certain level of encumbrance is reached. What does Moody’s look at?
Soriano, Moody’s: Calculating the level of encumbrance isn’t easy as you need to take into consideration covered bond issuance, along with committed OC and assets that are used for repo finance with the ECB. So, we start taking a close look at this when 50% of the assets of an institution are encumbered.
EUROWEEK: What about the potential for a bank problem such that as that suffered recently by DexMa. Is the environment today more or less likely to result in bank casualties compared to last year?
Eichert, Crédit Agricole: A jump to default because of a lack of liquidity is much less likely these days with all the support that’s available. There aren’t that many banks left that are purely wholesale funded like CIF. In addition to the funding issue, Dexia Group also had asset problems in some of its portfolios.
Haller, Crédit Agricole: Problem assets have decreased in value dramatically, not just in Spain but with many other regions in Europe. Unfortunately this situation with the asset side of banks’ balance sheets could easily lead to other cases like Dexia Group.
Hoarau, Crédit Agricole: I have no doubt about the resilience of the covered bond product as such, particularly in France where the legal framework and the privilege offered to bondholders is very strong. Apart from the mark-to-market pain, things will go well in the end.
Market participants buy the state support story here, but nevertheless the crisis has emphasised the danger of too much dependence on wholesale funding in the capital markets. In the case of CIF Euromortgage, the absence of deposits in the group has always been a weakness, although the business model has always been profitable. Sadly rating agencies downgrades have triggered a kind of self-fulfilling prophecy.
EUROWEEK: So banks will need to take more writedowns and raise more capital?
Haller, Crédit Agricole: Banks will need more capital, but it’s hard to get capital, not to say in some cases impossible. So the risk is this could unfortunately lead to another case like DexMa.
EUROWEEK: What is the best performing collateral?
Eichert, Crédit Agricole: Based on Moody’s collateral scores the best you can find is in deals backed by mortgages originated in Finland, followed by the Netherlands, Switzerland and then Norway.
James, Aviva Investors: We’re buyers of residential mortgage deals. The simpler the collateral the better it is, is a good premise to take. The perception of covered bonds is that in theory they should be quite simple and straightforward. From an investor’s perspective it just makes it easier to compare apples with apples. When you have to compare apples and pears, you have to make assumptions and when you start making assumptions you increase the probability of getting some of them wrong which can materially impact the return outcome.
Lanyi, Magyar Nemzeti Bank: We have a preference for residential mortgages over commercial mortgage pools. We think the performance of ship and aircraft Pfandbriefe are more correlated to economic cycles and have higher betas, so we have a conservative approach to them nowadays. With public sector backed deals you have a closer correlation to the sovereign risk which is good for core but less attractive in the periphery.
EUROWEEK: Do any others have a view on bonds backed by exotic collateral such as aircraft loans?
De Zagon, EIB: That’s a good principle because that collateral can change the correlation of the portfolio. All assets in our portfolios are supposed to be safe but they are correlated and anything that could change that and give a better mix, in terms diversification, is a good thing.
The main problem is that we need more resources to look into the detail. I will not just buy something because it looks good today, you have to dig deep and understand all possible risks.
James, Aviva Investors: Using collateral like aircraft is an interesting concept and as long as one can understand and evaluate the underlying collateral and structure in those types of deals, they can provide an interesting element of diversification.
EUROWEEK: But the deal was a success right?
Hoarau, Crédit Agricole: There’s no doubt that NordLB’s recent five year aircraft Pfandbrief was a success. However, by using aircraft loans the borrower achieved only a one notch uplift from the bank’s A3 senior unsecured rating. I would have expected a better rating given the size of the collateral.
Soriano, Moody’s: Our analysis reflects the historical evidence that the value of aircraft Pfandbriefe collateral is more volatile than conventional Pfandbrief collateral and it reflects the limited amount of relevant historical data available — especially following an issuer default.
EUROWEEK: What did you think about pricing?
Hoarau, Crédit Agricole: The final spread of 55bp over mid-swaps looked more or less like the mid-point between a private placement or sub-benchmark senior deal, and a classical public sector or mortgage Pfandbrief. Taking into account that the issuer does not have any established senior unsecured benchmark curve it’s a fantastic result.
EUROWEEK: How important was the Pfandbrief label?
Soriano, Moody’s: We apply a one notch uplift from the issuer rating purely because of the strength of the Flugzeugpfandbriefe legal framework which includes a 60% loan to value threshold based on a conservative aircraft lending value. The role of the issuer also contributes to the uplift through its management of the dynamic cover pool.
Hoarau, Crédit Agricole: The Pfandbrief label played a bigger role in the aircraft trade than in traditional deals. Investors bought the legal framework and track record of the Pfandbrief segment, and this drove the re-offer price.
EUROWEEK: What about RMBS?
James, Aviva Investors: We look at RMBS and many different kinds of loan pools. But we wouldn’t buy into an asset class where we weren’t comfortable we had the resources to evaluate the risks we were taking.
De Zagon, EIB: We are careful on everything to do with RMBS in pools because there is an extra layer of complexity. However, securitisation can be good for the economy in general. The RMBS market could help banks to finance mortgages and it’s a very reasonable risk — though much depends on the jurisdiction the mortgages are originated in. In some jurisdictions people tend to prioritise payments of their mortgage and in these cases I honestly think it’s a good asset class.
EUROWEEK: What about covered bonds backed by large commercial loans originated abroad?
James, Aviva Investors: We have a core capability when it comes to commercial mortgages, because we have a large global property operation and therefore the expertise to be able to evaluate those transactions. We definitely have core skill sets in some of those areas and look to make use of them.
EUROWEEK: What were the main reasons for putting in the second covered bond purchase programme (CBPP2)?
Mongars, Banque de France: We wanted to support the restart of the covered bond market which we thought was essential for the funding of European banks. And when we could see signs of the market holding in well after the LTRO, we naturally started to scale back as it became evident that external help was no longer necessary to the same extent.
EUROWEEK: How has the LTRO affected the second covered bond purchase programme?
Mongars, Banque de France: The LTROs provided a lot of cash for banks to invest and, at a time of concern about the creditworthiness of some financial institutions or certain sovereigns, it was natural that they would turn to safer assets. And among the choice of investible assets are covered bonds, which look quite attractive from a risk perspective. As a consequence of the positive participation in the LTRO, demand for covered bonds went up and this allowed the Eurosystem to slow down its purchases covered bonds in the second purchase programme.
EUROWEEK: What is the outlook for the covered bond purchase programme? Will it be closed at the end of October?
Mongars, Banque de France: The programme was there for a purpose; if it has served its purpose and there’s no need to continue, then we can stop. If it still has a role to play we can continue.
It is important to remember that CBPP2 is under continuous scrutiny. But naturally, banks have issued less after the LTROs and market conditions have improved considerably. This is one of the reasons why we have already slowed down the programme considerably and one of the reasons why we will monitor the programme to judge whether it’s appropriate in the present market conditions.
CBPP2 should focus more on the part of the curve which is not covered by the LTRO but beyond it. The two types of operations would then be more clearly complementary.
Lanyi, Magyar Nemzeti Bank: The ECB clearly indicated the strategic importance of the asset class, and therefore wants to maintain the continuous operation of the covered bond market as a funding tool for banks and wants to support the market in volatile times. On the other hand, it is more difficult to justify the purchases of Pfandbriefe and the lack of transparency for allocation among different jurisdictions.
De Zagon, EIB: In Europe the covered bond market is one of the main channels for financial institutions to access the market, which they really need. So it’s just intended to support the banks’ access especially in the context of the fact that unsecured senior debt is probably very difficult for lower rated the banks to issue at this time.
EUROWEEK: How has the intensification of the sovereign and bank crisis in Europe affected the syndication of covered bonds?
Hoarau, Crédit Agricole: This year has been marked by increasing volatility in markets and in investor sentiment which makes the job of syndication much more challenging, Aside from managing underwriting commitments we need to take into account market psychology and manage communication and headline risks sensibly. The need for transparency and the evolution of ICMA guidelines has changed some aspects of the book building process, including execution, communication, and even allocation.
EUROWEEK: How did soft sounding come about?
Hoarau, Crédit Agricole: Soft sounding was introduced just after the collapse of Lehman, during one of the darkest phases of the crisis. At that point you could have questioned how resilient the covered bond product was, and issuers could not afford to risk a partially subscribed transaction. There had been a couple of primary market failures in the past and the soft-sounding procedure and the use of whispered guidance were introduced. The idea was to gain comfort on the distribution potential of a deal and to help price discovery ahead of publically announcing guidance.
EUROWEEK: What were the drawbacks?
Hoarau, Crédit Agricole: These methods rapidly showed limitations. First of all, very often the result of the soft-sounding was not representative of actual reception. Sometimes it was misleading. From time to time, feedback received by investors just led nowhere. Elsewhere, there were suspected abuses. Some investors involved in the soft sounding just pushed back on price because the power was in their hands.
More recently regulators also introduced hard procedures around wall-crossing, and formerly regulated the way investors get access to primary market information ahead of the official announcement of a transaction. The game now consists of ensuring equal treatment, fairness and transparency.
EUROWEEK: What do you feel about order book inflation?
Hoarau, Crédit Agricole: ICMA has set some new rules and guidelines stipulating that any order related to the primary or secondary trading desk of bookrunners involved in the deal shall not be included in the description of the orderbook. It is as simple as that. But the rule does not distinguish support orders and genuine interest from trading desks. Orders from trading desks that cover existing shorts are filling pre-existing demand and not inflating it. Transparency is nice to have, but we should be given a little bit of flexibility.
EUROWEEK: What are your thoughts on covered bond CDS?
Hoarau, Crédit Agricole: The CDS market is still perceived as opaque and a market for arbitrage. I am not convinced the product will benefit the covered bond market, which has proven its resilience throughout the crisis. If you want to hedge the credit risk component of a covered bond that implies a partial hedge against default of the issuer, but covered bonds don’t necessarily default when the issuer collapses. Therefore there’s an inconsistency between the nature of covered bonds and the nature of CDS.
James, Aviva Investors: If one looks at the CDS market throughout the whole crisis it has actually performed very well and invariably offers better liquidity than the underlying cash market. But you need to be very conscious of the basis risk between the CDS and the cash bonds and you need to be able to manage and measure that risk. But it would be a natural development in the evolution of the CDS market, and would also facilitate relative value opportunities between covered bonds and CDS bank debt. It expands the opportunity set and increases the ability for investors to express relative value judgements.
Poli, Crédit Agricole: Most investors have already reduced their peripheral covered bond exposure to a minimum. CDS for core covered bonds are unnecessary as they trade close to their respective government bonds. Therefore CDS should in theory only be implemented for non-core covered bonds. But some asset managers have already put in place negative basis trades, buying Santander covered bonds and senior CDS. Going long covered bonds and short senior debt allows you to enter into a positive carry trade with strong credit protection. As a result, I don’t see any need to create CDS for covered bonds.
EUROWEEK: How could covered bond CDS introduce risks?
Hoarau, Crédit Agricole: CDS could also introduce new sources of risk for covered bonds. In the senior unsecured market we have already experienced the lack of correlation between cash price evolutions and CDS prices. If introduced for covered bonds CDS might capture a part of the liquidity in the covered bond market and discourage people from trading the cash.
EUROWEEK: Could CDS have a stabilising effect?
Hoarau, Crédit Agricole: CDS would only be beneficial for weaker names, and I’m not sure that investment banks would be ready to quote CDS for distressed covered bonds from weaker peripheral names. If they are then CDS could prevent forced selling and have a stabilising effect on the cash market. However it would also be a cheap and easy way to short the market, and the absence of a tool that allows you to do this is one reason for the limited volatility in covered bonds. All in all CDS could harm the market more than it helps.