The covered bond world has irrevocably changed in the last five years, but not all of its bankers have been able to kept pace with that change. Sovereign defaults, or even the break-up of the euro, are now possible, meaning so too is the first ever official default of a covered bond.
However, investors still only have one way to hedge their risk — and that’s to sell their exposure. The likes of bank treasuries would have little incentive to do this if it meant having to crystallise losses on positions probably still valued on their books at their original launch levels. Most would gamble on it being better to hold this paper than sell it.
But if they could buy protection through a credit default swap, investors could hedge exposures much more closely than is currently possible through CDS in the underlying sovereign or senior unsecured markets.
The cost of taking out protection would be much cheaper too, because the risk of a covered bond default should be less than that of a senior unsecured, or even government bond.
More importantly, that cost could be spread over several years — far preferable to having to take a debilitating one-off loss. So, from an accounting perspective, the development of a specific covered bond CDS market would be a very attractive option.
Yet as it stands, the covered bond market is effectively long only. Of course it is possible to go short specific bonds and try to find them in the repo market, but this is an imperfect trade as they can be expensive, or impossible, to find there.
And, since many of the riskier peripheral covered bonds have already been pledged to the European Central Bank, they cannot then be borrowed in the bilateral repo market.
Missing the point
Some bankers still oppose the idea of a CDS market, as the ability to express a two way view more easily would almost certainly lead to greater volatility. But they are missing the point.
The increase in volatility could well be accompanied by improved liquidity and tighter bid/offer spreads — which is surely a good thing.
Large parts of the covered bond market simply do not trade currently because holders are unable to execute in size without causing the price to shift. But if they were able to express their view, or hedge their position, without having to incur a potentially unnecessary loss, then the motivation to deal would increase.
Covered bond liquidity has always been a bugbear of the market, particularly in the structured notes sector. Triple-A rated covered bond structured notes are generally unlisted, so are not eligible for ECB repo purposes — making them even more difficult to hedge.
Large holders of these notes were typically CDO vehicles, which have predominantly been unwound since 2008 leaving their sponsors with large and unwieldy positions.
Aside from improving liquidity and the ability to hedge positions there is also a strong argument in favour of covered CDS from participants looking to take advantage of relative value. Covered bond CDS would provide the missing link between senior unsecured and sovereign CDS, enabling investors to express relative value judgments on their fundamental views of the inherent credit risk.
But as the market stands today, trades cannot be done because, held to ransom by technical considerations that so adversely impact liquidity, the fundamental view cannot be expressed.
It is time for the doubters to move with the times.