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FIGCovered Bonds

Market Conditions

EUROWEEK: Bank deleveraging, a surfeit of central bank liquidity and falling loan production have affected the market, while regulations look likely to cement in a long term structural bid from the institutional side. How long can we expect this technically supportive backdrop to continue exerting its influence on spreads?

Juhasz, World Bank: I suppose the situation may start to change as the ECB’s long term refinancing operation (LTRO) will run out at some stage and bank deleveraging will have to come to an end too. Added to which covered bonds are a preferred instrument in Europe and they are getting much more popular around the globe as we see lots of new countries approving legislation, so there will be additional supply. Maybe the European supply will be low but outside Europe this will become a very interesting tool.

Eichert, CA-CIB: We will probably see more peripheral banks being encouraged to test the market and raising the ECB repo haircut for retained deals is one way to encourage that, but they’re unlikely to issue the €70bn-€80bn that would be needed to bring net issuance into positive territory. The problem is that you have some pretty big sized entities that are in run-off mode, such as Hypothekenbank Frankfurt and the public sector programmes of German and Italian banks. That element of negative issuance is going to be around for the next 10 to 20 years.

Prokes, BlackRock: Since I’m not 100% sure the economy can take the pace of bank deleveraging I wouldn’t be surprised to hear, at some point, that the balance sheets of banks need to increase again to increase lending in the real economy, otherwise we’re all in for painful times. There are a few signposts suggesting that regulators are getting more open to the idea that banks need to grow their balance sheets in specific areas. If you clean up banks’ balance sheets but the economy collapses, nobody wants that. It’s already very bad with zero growth but what if we get a large European-wide contraction in growth?

Denger, MEAG: The market is already undersupplied with so called high quality bonds. Deleveraging and central bank liquidity is likely to drive investors into other types of bonds or direct investments. If the market regains trust in the euro periphery, the lack of high quality bonds should have a very positive effect for covered bonds from these countries.

Cortazar, BBVA AM: It’s clear that banks are prioritising issuance of loss absorbing subordinated debt to try to protect their senior debt, while at the same time they are trying to lower their leverage ratios. This unfortunately means that covered bond supply is likely to remain low for the foreseeable future.

Goldfischer, CA-CIB: Mortgage origination has slowed in line with the macroeconomic environment, so I don’t think the undersupply of covered bonds will be corrected in the near future. As the market normalises most banks will want to preserve their collateral just in case there’s a new bout of volatility.

Eichert, CA-CIB: Even if the pace of issuance picks up later this year it will still be net negative to the tune of about €40bn by the end of the year. Over the next two to three years we’ll reach a redemption plateau of around €150bn which means that even if we pick up issuance from current levels, it’s likely to be a long time before we reach net positive issuance.

Hoarau, CA-CIB: The start of the US covered bond market could be a game changer but it has been under discussions for years and I don’t see it coming shortly.

Lavastre, CDC: Today power is in the hands of issuers. With the economic crisis, the drop in bank lending and the excess of liquidity provided by central banks, issuers do not require significant funding and it looks like the market will remain undersupplied, which has obvious consequences for spreads.

Prokes, BlackRock: It will be very important to see when and where we get the first wobble in the senior market, in terms of senior investors in small banks being bailed-in for example. At that point we will potentially see senior risk being repriced which may cause a return to covered bond issuance. So at some point we will start to see healthier covered bond supply — possibly in the next couple of years.

Denger, MEAG: I don’t think we’ll see spreads return to the widest levels unless the market judges that the eurozone is going to collapse. In terms of performance potential from current levels I imagine that we have seen the lowest yields for countries like Germany but for the peripheral nations we may well see a further fall in yields.

Lavastre, CDC: I also think we have reached the tightest level spreads can go. With the loss of sovereign support and the prospect of bank downgrades, the impact of bail-in which could take effect in near future, spread levels could increase before the end of this year.

Hoarau, CA-CIB: A prospective SSA widening could also drag covered spreads wider as holders take advantage of relative value and switch into agencies.

Prokes, BlackRock: I’m quite happy to use any prospective weakening to add some covered bonds exposure to the funds, especially since I think we will ride this year out with a negative supply.

Cortazar, BBVA AM: European interest rates are likely to remain low for around three years so the risk of a European rate rise is more a long term consideration. My main concern relates to the impact of the Fed’s action on European markets.

EUROWEEK: On the other hand, Europe isn’t exactly in a fundamentally strong place and if serious doubts about the viability of the monetary union resurface I guess all the technical arguments for spreads to remain tight can all get thrown out the window?

Hoarau, CA-CIB: Now and again volatility will return just when people forget about the fundamentals and valuations get too irrational. When I heard about the city of Detroit filing for Chapter 9 bankruptcy protection I wondered how many cities or regions in non-core Europe could find themselves facing a similar situation.

Access to wholesale funding in senior unsecured format has been shut for most second tier peripheral names and their reliance on the ECB for funding is still far too high. And it doesn’t bear thinking about how many smaller banks will be able to meet their capital requirements.

You have to ask how long this situation is sustainable when you don’t see any sight of economic recovery and when unemployment rates are rising to record highs every month.

But if things start to get bad I don’t think the ECB will hesitate to consider a third LTRO, which would be a game-changer in Europe.

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