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Financial Institutions: Covered bonds fight for space as non-preferred issuance rises

Banks will prioritise funding that helps meet their regulatory ratios in 2018, but covered bonds will continue to play a pivotal role because they provide the cheapest cost of funding. By Bill Thornhill

As a result of looming regulatory targets for the amount of bail-inable funding that must be raised, pressure is building on banks to raise vast amounts of senior funding that can be written down in the event of their resolution.

The minimum requirement for own funds and eligible liabilities (MREL) and the Financial Stability Board’s total loss-absorbing capacity (TLAC) standard have set the specific regulatory targets for the amount of bail-inable funding that must be raised.

But the clock is ticking: the TLAC standard is set to apply to Europe’s largest banks from the start of 2019 and MREL targets may need to be met by 2022. The Single Resolution Board, the authority in charge of bank resolution in the European Union, estimates European banks have a €47bn shortfall of qualifying debt that must be issued.

Despite this urgent need, they are widely expected to combine this more expensive debt issuance with covered bonds to bring down their overall blended cost of funding. 

Senior non-preferred, or senior debt issued from a firm’s holding company (holdco), are the funding tools of choice that count towards issuers’ regulatory targets. However, although the cost of this debt fell by 25bp-50bp last year, for a typical single-A rated borrower looking to borrow over seven years it remains 75bp-85bp more expensive than covered bonds. This difference is even more for lower rated banks and longer maturities.

Christopher Agathangelou, head of fixed income syndicate at NatWest Markets in London, says many issuers have now completed their strategic capital plans and the market is poised to “loosen up” for more generic funding operations in 2018. He is “reasonably bullish” on the supply outlook for deals that help meet issuers’ regulatory targets, and for covered bonds.

Borrowers will adopt a “barbell funding approach” he says, “using covered bonds for duration and shorter senior non-preferred for MREL and TLAC purposes”. This, he says, is the best strategy for protecting net interest margins.

This is exacerbated by the fact that many countries do not even have a legal framework in place allowing their banks to issue such debt.

French, Belgian and Spanish banks have senior non-preferred laws, while those in Switzerland and the UK can issue debt from their holdcos. In contrast, most other European nations still do not have relevant laws and borrowers in these countries, along with many outside Europe, may not be in a position to issue qualifying deals until mid-2018. 

“There are a number of regions inside and outside Europe that don’t have clarity on MREL/TLAC requirements — such as Australia, Scandinavia and Canada — so you still have a number of big issuers that have not started out on that journey,” says Shashank Tandon, who works on the fixed income syndicate desk at Credit Suisse in London.

The short timeframe banks have to meet the regulatory deadline implies that the market could be inundated with supply as issuers scramble to reach their targets. That volume, along with potentially less stable capital markets, risks ruining the strong tone in covered bond markets that allowed SNP spreads to tighten by up to 50bp last year.


The strong market conditions in 2017 meant that the cost of issuing SNP relative to tier two debt fell for French issuers from 45%-50% in January to 36% by the end of the year, according to the head of covered bonds origination at Société Générale, Ralf Grossmann. 

Grossmann says banks will try to fill their MREL buffers as much as possible with senior non-preferred but warns “there is a fragile balance as issuers could turn more to covered bonds if market volatility rises”. 

The tight implementation period and high volume of paper that needs to be raised has been the cause of much anxiety. “There has been a lot of talk of pushing out the MREL implementation date and, if that gathers momentum, issuers won’t necessarily want to flood the market with senior non-preferred,” says Agathangelou.

Because issuers will want to protect net interest margins, he believes there is potential for covered bond supply to improve, especially from banks in Europe’s periphery, where the cost of issuing SNP is expected to be higher compared with those in core Europe.

Senior preferred cuckoo in the covered bond nest

Another important element that issuers are likely to take into account in their funding mix is the market for senior preferred. Banks in countries that do not yet have an SNP legal framework have continued to issue senior preferred, which ranks above senior non-preferred in insolvency but is subordinated to covered bonds.

Senior preferred should be priced between covered bonds and senior non-preferred, but because it is going to be gradually phased out and replaced with senior non-preferred, it will become increasingly rare, which may confer an additional scarcity premium. 

For the time being, there is still a material spread differential between senior preferred and covered bonds, particularly at the long end. However, once the difference moves inside 20bp, “senior preferred starts to become the more viable tool,” say analysts at Crédit Agricole’s research team.

Senior preferred clearly offered the most viable funding for Canadian and Australian banks in dollars in the three to five year area during 2017, as the spread difference to covered bonds was well inside 20bp. 

But the spread versus senior preferred is not the only factor affecting prospective supply. The net stable funding ratio (NSFR) has also played a role in Australia and Canada.

The NSFR obliges banks to match longer-term assets and liabilities. Unencumbered mortgages require stable funding of 65%, which means a bank that funds these with senior unsecured has an NSFR above 100%. But encumbered loans that form part of a covered bond pool, which includes over-collateralization, need 100% stable funding. The proposed NSFR rules therefore incentivise banks to issue senior unsecured debt in preference to covered bonds.

Australian and Canadian banks have implemented NSFR rules in line with Basel III proposals and this contributed to lower covered bond issuance in 2017. European banks are waiting to see how the European Commission will implement NSFR rules, hoping that covered bonds will get a more favourable treatment compared with the Basel III proposals.

“European issuers are watching this development closely as their NSFR rules are due to be finalised and this will also influence the relative utility of covered bonds versus senior,” says Michael McCormick, who is head of covered bond origination at Credit Suisse.

Another crucial factor that is certain to shape covered bonds in 2018 is the impact of the European Central Bank’s tapering of asset purchases. In October 2017 the ECB said it would halve net asset purchases from €60bn a month to €30bn from January until September 2018. But since it has more flexibility to taper in its largest programme, the public sector purchase programme (PSPP), it may not necessarily reduce covered bond purchases.


Cristina Costa, a covered bond analyst at Société Générale, says that when asset purchases fell from €80bn to €60bn per month in April 2017, most of the decrease was in the PSPP programme and the effect on covered bonds was marginal.  She expects “the same pattern” in January 2018, with covered bond net purchases likely to continue unchanged at a rate of €2bn-€3bn a month. “It won’t feel like there has been much change to begin with,” she says.

But Costa warns that the market could become more nervous from June, “as people will be looking for hints from the ECB to assess whether tapering will end or continue beyond September”. 

A further two opposing factors are also going to impinge on the market. A €42bn fall in euro covered bond redemptions to €88bn will have a negative influence. Across euros, sterling and dollars redemptions will fall by €66bn equivalent to €115bn, according to Crédit Agricole analysts. A lower refinancing need means borrowers will be less compelled to issue replacement deals.

TLTRO influence

Conversely, the refinancing of liquidity borrowed under the targeted longer-term refinancing operations (TLTRO) — should positively influence supply.

Most TLTRO I drawings were rolled into TLTRO II and, under the first series of that programme — which does not mature until 2020 at the earliest — almost €400bn was borrowed. Analysts at Commerzbank say partial early repayments, which can start from June, could make sense for some banks facing large maturities.

However, they do not believe the bulk of TLTRO repayments will properly get under way until a year before their actual maturity — which is 2019. “We do not expect the replacement of TLTROs to boost the market [in 2018]” say the analysts. That contrasts sharply with views of analysts at Crédit Agricole, as well as some market participants, such as NatWest Market’s Agathangelou.

He says that waiting until 2019 to refinance the TLTRO risks putting pressure on the market and, given the large amount that needs to be repaid, issuers “will choose to term out over a 24-month period and start [refinancing] from the second half of 2018”. 

Southern European banks borrowed the most TLTRO financing and, according Boudewijn Dierick, head of flow ABS and covered bond structuring at BNP Paribas, “that’s potentially where you are going to see more growth in covered bond volumes” coming from.   

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