Central banking intervention is set to continue shaping the debt capital markets, no more so than in covered bonds which are the target of the European Central Bank’s third purchase programme. This, along with the targeted long term refinancing operations (TLTRO) and negative deposit rates, will lead to lower supply and a further tightening in spreads.
But for banks that reside outside the eurozone, the expected contraction in the cost of funds is likely to represent something of a bonanza. With the ECB set to absorb large proportions of primary and secondary supply, the availability of bonds will become even more constrained. This is likely to drive buyers to look more closely than ever at covered bonds originated outside Europe — and other alternatives.
Meanwhile, back inside Europe, the extraordinary measures may not be enough to stimulate loan demand and revitalise the bloc’s economy in the near term. Though October’s asset quality review and stress tests should set a high watermark in terms of European bank balance sheet quality, many institutions will continue shrinking their loan book to meet strictly defined leverage ratios. This is likely to mean that banks will prioritise any form of financing that absorbs losses — particularly if it is cheap and popular with investors, and it does not encumber their balance sheets.
This process stands to constrain credit, creating dis-inflationary forces that may force the European Central Bank to take even bolder steps to kick-start the flow of money. But whether the small to medium sized enterprises, which are the beating heart of the European economy, have the confidence or ability to borrow will be less certain. Banks that have been assiduously cleaning their balance sheets may only be prepared to expand credit where it suits them and lend to their least risky clients.
The covered bond supply drought is not expected to change much over the course of next year or the year after, but in 2017 the pace of redemptions will markedly fall. And by that time, when banks will be looking even stronger, demand for credit growth should start to pick up. In conjunction, these factors should revitalise covered bonds sustaining its long term future.
The following issuers, investors and bankers joined GlobalCapital in late August to discuss the outlook for covered bonds:
Bruno Costa, head of funding,
Caixa Geral de Depósitos
Franck Mugat, portfolio manager,
Allianz Global Investors
Frédéric Ségur, portfolio manager,
La Banque Postale Asset Management
Olaf Pimper, global liquidity/risk management,
group treasury, Commerzbank
Ralf Burmeister, portfolio manager,
Deutsche Asset & Wealth Management
Richard Coyne, senior manager, group funding,
National Australia Bank
Sami Gotrane, financial markets manager, Caffil
Timo Boehm, portfolio manager, Pimco
Vincent Hoarau, head of FIG syndicate,
Crédit Agricole CIB
Waleed El Amir, head of long term funding,
group finance, UniCredit
GlobalCapital: What does the ECB’s third covered bond purchase programme mean for the market?
Vincent Hoarau, Crédit Agricole CIB: The programme, which starts in October, will exacerbate illiquidity in the secondary market. It’s very likely to accelerate the spread tightening move as few market makers or investors will want to offer bonds.
GlobalCapital: How did covered bonds react following the news?
Hoarau, Crédit Agricole CIB: The moment ECB President Mario Draghi announced this purchase programme, peripheral spreads dropped 10bp, though Banca Carige’s junk rated covered bond dropped by 15bp. Core markets immediately tightened by up to 5bp.
GlobalCapital: How do you expect covered bond supply to shape up over the rest of this year?
Waleed El Amir, UniCredit: Even though the market is a little volatile, I think there’s going to be a lot of supply in September for what needs to come. But after that, you may see a big drop in issuance. Funding volumes will drop for pure liquidity products on the back of TLTRO which funds 7% of a bank’s loan book. That’s a lot of funding coming through the door at very cheap rates, so why would you issue senior, covered or ABS?
GlobalCapital: What does the purchase programme mean for issuers from outside Europe?
Richard Coyne, National Australia Bank: Basis markets will remain a major determinant of relative value. Having said that, we would expect increased issuance from non-EU borrowers given the very supportive technical backdrop.
GlobalCapital: What are your thoughts about how banks are likely to approach the TLTRO in terms of the unconditional liquidity that is provided for the first two years?
Frédéric Ségur, La Banque Postale Asset Management: Given the absence of dissuasive penalties against any potential use of TLTRO for carry-trade strategies, we don’t expect that all the money borrowed over the two year horizon will be redirected to the real economy.
Franck Mugat, Allianz Global Investors: Agreed. In the current environment of very low interest rates, banks are likely continue with the carry trade strategy, with peripheral debt markets taking the most advantage of this. However, I question the amount that will be used for lending to the EMU non-financial sector. The ECB has offered generous conditions with TLTRO, which is the cost of the main refinancing rate at the start of the respective tender plus a spread of 10bp. Volumes could reach between €400bn and €800bn.
Sami Gotrane, Caffil: The overall deleveraging trend will continue, despite the TLTRO. We don’t see many banks using the unconditional LTRO money to increase their balance sheets again. With a few exceptions, this liquidity is essentially going to replace short dated senior issuance. Looking at the covered bond market, the TLTRO will also have some impact on short dated covered bond issuance. This will mainly concern non-core issuers, with most other issuers using their covered programmes for maturities of five years and above. Last but not least, the LTRO will most likely reduce the interest by issuers for SME-backed covered bond programmes, as the cover assets are relatively short dated and very often directly eligible for the TLTRO.
GlobalCapital: What are your thoughts about how banks are likely to approach the TLTRO over the second and third years, when liquidity is contingent on net new SME and corporate lending?
Olaf Pimper, Commerzbank: As long as production capacity utilisation rates are still low and SMEs are hesitating to invest, loan production improvement might not be seen.
El Amir, UniCredit: The non-core division of the UniCredit Group is projected to de-lever by €50bn in the next five years, so that’s effectively a significant headwind. From March 2015 TLTRO liquidity will be measured in terms of net incremental lending which will be a challenge for us.
Secondly, in terms of the transmission mechanism from the ECB, we’re not necessarily convinced that, just by purely reducing the cost of financing to the banks, you actually end up getting more demand for loans.
Bruno Costa, Caixa Geral de Depósitos: Demand for bank lending in some countries, such as Portugal, has decreased due to such factors as deleveraging of households and companies, high unemployment and lack of confidence to invest in new projects or expanding operations, due to low growth both in the domestic economy as well as in those of major export partners.
GlobalCapital: Do you agree the LTRO was effective in supporting spreads?
Hoarau, Crédit Agricole CIB: When the ECB introduced the first LTROs there was a strong incentive for peripheral banks, and mainly those in Spain, to execute carry trades and to purchase cheap peripheral sovereign debt or covered bonds with a view to restoring profitability.
Spreads were so elevated that a mid-term rally was foreseeable given the strong technical support and central bank liquidity injected in the market. Over the last 18 months, spread compression has been phenomenal across asset classes and jurisdictions.
GlobalCapital: Spreads have come a long way since then, can we really expect the TLTRO to work as effectively?
Hoarau, Crédit Agricole CIB: Today, banks will use TLTRO as a pure two year funding tool and cheaper money to refinance assets on balance sheet. The all-in cost of funding will diminish, but I think carry trades will be rather limited as the risk of a spread correction cannot be ruled out.
GlobalCapital: Do you think that the TLTRO will really help improve lending in the present circumstances?
Hoarau, Crédit Agricole CIB: Lending to SMEs will resume when evidence of an economic recovery starts to build and we see a return of business confidence across Europe. Looking at the recent data flow in Germany and France along with the geopolitical situation, I fear that we are far from a global economic turnaround. The falling inflation rate, not to speak of deflation risks, and the already low level of interest rates — are discouraging signals.
GlobalCapital: SME loans consume a lot of capital which banks are trying to conserve and build. Will the TLTRO change that?
El Amir, UniCredit: Banks cannot simply lend to any client because they may have an asset quality problem, and we’ve just come out of a very difficult cycle. The risk is that banks will prefer to park liquidity in high quality investments, rather than lend and potentially have an asset quality problem.
Ralf Burmeister, DeAWM: With capital ratios being so much in the spotlight and in a situation where the banks are being stress tested specifically regarding their capital ratios you would probably expect them to be extremely cautious. SME risk-adjusted margins are good, but the question banks are likely to be asking is — when do they expect losses to hit the loan portfolio?
If they assume it is sooner rather than in the medium to long term then they are going to be more reluctant to make loans. Letting the SME loan portfolio run down should pay off, but if you have to show losses that is problematic these days for banks to explain to regulators and/or shareholders.
GlobalCapital: Can we therefore assume the TLTRO is more likely to be taken for two years as opposed to four?
El Amir, UniCredit: We will look at this as two year funds, because we’re not clear, given our deleveraging targets which we need to deliver on, whether we’ll be able to generate a sufficient amount of net new lending but we’ll have to see how we get along.
Ségur, La Banque Postale AM: The conditionality relative to the TLTRO after two years would not be the main driver of an improvement in SME loan production. Demand for credit should increase thanks to better economic conditions and an improvement in banking sector fundamentals.
Costa, CGD: Confidence needs to be restored and investment conditions need to improve before we see a positive impact in bank lending volumes. So it is uncertain how much such a reduction in lending costs will stimulate lending growth in the short term. On the other hand, we are already seeing an increased competition between banks’ lending to export-driven SMEs.
GlobalCapital: As the TLTRO effectively provides meaningful funding for two years it therefore shouldn’t compete with the long term funding provided by covered bonds should it?
Sami Gotrane, Caffil: With a few exceptions, this liquidity is essentially going to replace short dated senior issuance.
Burmeister, DeAWM: My best guess is there will not be too much cannibalisation if you talk about the unconditional phase of two years at least when it comes to covered bonds.
GlobalCapital: Caffil’s covered bond funding is mostly in the long end but the TLTRO will only provide liquidity at the short end which in theory means it shouldn’t affect you, is that right?
Gotrane, Caffil: We are active at the longer end of the curve as our loan business with French local authorities is long dated so yes, the LTRO will not directly affect supply and demand in this maturity segment. However, there will also be some spill-over effect as the different maturity segments are interconnected. For example, we already see a lot more interest from bank treasuries for transactions up to 10 years than we saw in the past. The same can be observed for central banks, which are increasingly looking at medium and long maturities of core covered bond issuers. So, indirectly there could be a positive impact for issuers like Caffil with long dated funding needs.
GlobalCapital: Are there any lessons to be learned from the Bank of England’s experience with the Funding for Lending scheme — which banks practically stopped using after it was more narrowly defined to net SME lending and mortgage lending was stripped out?
El Amir, UniCredit: Yes, it doesn’t follow that a lower cost of funding will necessarily lead to more loan demand. So effectively if banks cannot allocate the funding to the SME sector, they will do the simpler transaction, which is to lend to corporates where you can get a much larger volume done with more ease.