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ECB must slow covered bond purchases or risk the market’s longer term damage

Faced with shrinking yields, covered bond investors have been deserting the market. Unless the ECB moves out of the way and switches to sovereign purchases fast, there is a real risk that these buyers will not be there when the extraordinary stimulus measures now being delivered are taken away.

“Many market players are concerned that investors may be pushed out of the market and may not be willing or able to readily return after June 2016,” said Fitch in a report on Monday. At that time, the third covered bond purchase programme (CBPP3) and targeted longer-term refinancing operations (TLTRO) will have ended, and quantitative easing (QE) will be on the way out.

At the same time as Fitch delivered its verdict, the ECB reported that it had bought €37bn covered bonds under CBPP3, of which as much as 80% is estimated to have been in the secondary market. As yields have tumbled towards negative territory at the short end, investors have taken profits and sold bonds to the only buyer in the Street.

The ECB’s buying has pushed a good section of marginal demand out of the market, and it is not sustainable.

Based on a survey of 52 investors conducted in December 2014, Fitch said 58% would switch to asset classes other than covered bonds. Having restructured their teams to take advantage of alternative assets these marginal buyers will not necessarily be capable of jumping back into the market when yields return to more interesting levels. And without those buyers the market will become less liquid.

The best hope for covered bonds is that the ECB cuts purchases for the next month or so and switches its attention to preparing its sovereign bond programme. 

Now the QE announcement is in the open, the central banks do not need to carry on the frenetic pace of covered bond purchases to retain market confidence — spreads will stay stuck until sovereign buying begins. When that happens, then covered bonds should once offer some value relative to sovereign bonds, encouraging marginal investors to keep their covered bond capabilities live.

The QE announcement includes covered bonds in the €60bn per month, but given the havoc it has already wreaked on the market, let’s hope the ECB can moderate its covered bond investments enough to keep marginal investors on board.

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