To a logical mind, the covered bond market of 2014 might not seem to make much sense. Why, for instance, do stronger credits often face greater execution risk in printing debt than their lower rated peers?
But in this inside-out, post-crisis world of ultra-accommodative monetary policy, that is the situation in which covered bond issuers find themselves. Yields in this asset class have never been very exciting, but the prevailing rates environment has rendered even the most traditional buyers apathetic about shorter dated paper from core European borrowers.
There have already been some muted responses this year to well-rated deals — Commerzbank’s €500m five year and Deutsche Pfandbriefbank’s €500m eight year being prime examples — while 2014’s three biggest oversubscriptions have come from UBI Banca, Caixa Geral de Depositos and Credito Emiliano.
Investor influence
Tight spreads are not going away. Net supply year-to-date has been higher than in 2013, but this is mainly down to the fact that the bulk of redemptions come later this year than they did last. Bernd Volk, head of covered bond research at Deutsche Bank, predicts that negative net supply will increase during 2014 from €7bn to €30bn-€50bn.
“Spreads should finish this year tighter than they started,” he says. “I don’t see a trigger for significant covered bond market-specific change at the moment. Besides ongoing strong regulatory support, loose monetary policy, ultra low yields and low supply remain the key drivers.
“We are seeing bank treasuries buying longer bonds than they did previously and fund managers buying higher shares of periphery bonds. Second tier Italian covered bonds trade still with a significant pick-up to prime Italian covered bonds, probably one of the few opportunities left in the benign market environment.”
With supply scarce, covered should be an issuer’s market. But the investor push for better returns is influencing issuers’ choice of maturity more and more. Some banks have tried to offer asset managers as much yield as possible by gravitating towards seven years, while others have tried to capture insurance company interest by hitting 10 years-plus (see chart).
External catalysts
There are catalysts for change lurking. One of covered bonds’ biggest problems in terms of supply is the lure of its riskier brother, senior unsecured. Not long ago covered bonds offered a safe route to market for smaller periphery banks with high borrowing costs, but now senior is exceptionally cheap on a relative basis. In addition, periphery banks are typically operating in economies that have experienced virtually zero loan growth in the last two years.
This is where things could begin to change. Growth is slowly returning to Europe and the European Central Bank has so far remained coy over the need for either extending the long-term refinancing operations or tweaking them in favour of SME lending. If the LTRO taps were to remain off, many lenders may be shifted back towards covered by their desire for cheaper funding.
Theoretically, the bail-in rules scheduled to take effect in 2016 should also widen the senior-covered differential, but investors clearly consider the extra risk of haircuts extremely remote in practice. Their judgment appeared vindicated earlier this year when Austria’s finance minister Michael Spindelegger decided insolvency was the cheapest option for the country’s taxpayers in dealing with troubled Hypo Alpe-Adria, only for the central bank and regulator to protest fiercely that the move would destabilise markets.
The ECB could also have a hand in changing the covered picture through its asset quality review and stress tests, due to be completed in November. Some market participants fear that problems identified at specific lenders could rapidly correct spreads in a market where there is rarely any real selling pressure and volumes are light.
“If there was to be a counter-movement in spreads, though I don’t see it happening at the moment, it could be very abrupt due to low market liquidity,” says Volk. “If some investors start selling spreads could widen significantly.”
Few expect anything to spoil the picture for issuers this year. As long as they do not use the supply drought to squeeze yield-hungry investors, many of them will be printing successful deals at near-record tights for many months to come.