The covered bond good times won't last
Covered bonds have had a great start to 2016, in terms of supply, spread performance, and participation in the market from real money investors, but this trend is unlikely to hold. Central bank action, once again, will corrode the market from both supply and demand sides.
Euro covered bond supply has amounted more than €66bn so far this year, which is up almost 50% compared to the first quarter of 2015 and the highest first quarter volume since 2011. But as the market heads into the second quarter it seems almost inevitable volumes will fall — as has been the case for the past five years.
Since 2011 covered bond supply has on average fallen by about 40% from the first to the second quarter, more so in years where the first quarter supply has been strong. But even apart from the usual seasonal downswing, the Targeted Longer Term Refinancing Operations (TLTRO) will also diminish the supply outlook in covered bonds.
Though the TLTRO can’t compete with the long end funding that covered bonds provide, it will provide four year term funding at a negative interest rate of up to -0.40%. For most covered bond issuers in Europe’s periphery this is going to be something like 50bp cheaper than they could achieve with market based funding and a number that will considerably improve their net interest margin and profitability.
And it’s far from clear whether the likely thin supply will tighten spreads further. Covered bonds have already come a long way this year, leaving the buyside sitting on considerable profits.
Some peripheral covered bonds already trade nearly 50bp inside their reoffer level. But many double A-rated Spanish and Italian bonds now trade broadly in line with triple A-rated Scandinavian and Canadian deals, meaning the relative value that drove the peripheral tightening has all but disappeared.
With valuations already stretched, it’s difficult to see why real money investors should remain in the market over the longer run. But central bank buying will carry on supporting spreads, even as money leaves the market. In fact, given the expected decline in primary supply, the central bank will need to scour the secondary market for offers even more aggressively.
In the certain knowledge that spreads can no longer be fundamentally justified, real money buyers, once again, will be encouraged to take profits and sell out their holdings to the only buyer in the Street, with a pernicious effect on the market.
The covered bond year has started strong, but it won't last.