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The covered bond paradox: the best and worst of times

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Surging covered bond issuance that is printed only for repo at the central bank and official sector purchases means that the asset class is now less relevant for market funding purposes than ever before. If this continues, the systemic importance of the €2.7tr global market will be undermined just as efforts to develop it look to bear fruit.

Systemic support for covered bonds will diminish if central banks eclipse private investors as the banking system’s principal funding source in times of stress, Moody’s said in a report earlier this month. 

Its report came weeks after the European Covered Bond Council proudly announced the latest figures detailing the size of the global covered bond market.

The ECBC proclaimed another step increase in outstanding volumes from €2.6tr in 2018 to €2.7tr in 2019. In all there are 439 covered bond programmes managed by a record 329 issuers in 34 countries. This sheer scale confirmed “the systemic importance of the market,” said the ECBC.

But what the ECBC did not say was that, in contrast to the global financial crisis when publicly placed covered bond issuance surged to a record, 2020 will likely be one of the worst years for publicly syndicated issuance. 

If that were to continue, the perception of covered bonds' importance would weaken, lessening the likelihood that authorities take action to benefit the covered bonds of a failed bank, according to Moody’s.

2020’s 50% surge in repo eligible issuance from 2019 to €576bn starkly illustrates the problem. As a result, publicly placed issuance that is sold to real investors will shrink. 

This is to the detriment of issuers, investors and the financial system as a whole.

This year around €20bn more covered bonds are expected to be redeemed than issued. And of the diminished amount that surfaces, the ECB will take up to 30% of any eligible deal in the primary market, and a further 40% in the secondary market.

It is good to see deals issued this week go so well, but it should not be forgotten that the scale of unprecedented central bank support is slowly suffocating the market. 

This has “diminishing banks' ability to use covered bonds to consistently and reliably access market funding in future crises,” and once investors have left the market, they may be slow to return, Moody's grimly warned.

The ECBC is right to be shouting from the rooftops about the market’s sheer size, breadth and scale. But if covered bonds are to really, truly live they need to be treated more like a market instead of a policy tool.

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