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FIGCovered Bonds

Shocks and disappointments

GlobalCapital: What’s your view on the extent that we can expect other shocks or disappointments affecting spreads? El Amir, UniCredit: If you look at the subordinated product like lower tier two, that’s been hit pretty hard across the board. So it certainly feels like people have taken Argentina, disturbances in Israel, BES, and everything else, as an excuse to take profits.

Also, I think investors will be more reluctant to take big positions before the AQR, which means October and the early part of November become a sort of navel gazing exercise, as people digest those results. So we could be in for a pretty volatile ride between now and Christmas.

Mugat, AGI: If we take into consideration the place of covered bonds in banks’ capital structures and all the efforts made by regulators to strengthen covered bond product, it’s difficult to see what could trigger a strong widening. However, European growth concerns could temporarily hit government bonds potentially affecting covered bonds.

Costa CGD: There will always be shocks. Nevertheless, covered bonds have proved, even in the last few crisis years, to be more resilient than other securities. Spreads of covered bonds are usually more stable given the relatively higher rating and the fact that traditional covered bond investors tend to hold on to the bonds for long periods or until maturity.

Ségur, La Banque Postale AM: If peripheral sovereign spreads continue to tighten, we could see further spread compression with specific stories like Spanish banking sector consolidation or the AQR requirement for Italian banks resulting in more compression. BES was a one-off, driven by a specific lack of governance with no read-across for European banks.

Boehm, Pimco: Shocks are part of the game as we have recently experienced with BES or Hypo Alpe Austria and political unrest in the Ukraine. We also have a lot of moral hazard in the covered bond market because some investors may be under the misconception that because covered bonds are exempt from bail-in, they cannot default.

Basically these events create volatility and in the end this is actually quite positive because it can provide opportunities for investors who are close enough to the market to invest with opportune timing. Every investor tries to identify the right timing to buy or sell, as do we, but it’s never easy. But what may appear to be suboptimal timing in the short run usually becomes good timing in the long run, when one has done proper credit analysis.

Gotrane, Caffil: It is obviously difficult to predict where potential problems might come from. Investors are looking closely at the outcome of the AQR. But it’s probably more a risk for individual issuers than for the market as whole, unless the results provide us with a huge surprise. Covered bond spreads have resisted geopolitical tensions well up to now so it would probably take a very dramatic event to take the market by surprise.

Ségur, La Banque Postale AM: We’re not too worried about the stress test results. In Spain they were realised in 2012 with definitive recapitalisation needs and in Italy recapitalisation is already underway. However, Austrian banks could be at risk due to their exposure to central and eastern European mortgages, some of which include foreign currency denominated loans.

Coyne, NAB: It’s interesting in the case of BES or other sentiment-driving risk events, when we’re looking at Australian covered bond spread performance, our outstanding deals have performed extremely well. Even if I look at our outstanding senior curve, volatility has not had an impact on our spreads, which highlights the underlying bid tone for high quality product irrespective of the market backdrop.

Pimper, Commerzbank: The impact of BES shows that investors can differentiate well between problems arising in a single entity, rather than punishing the whole market.

Burmeister, DeAWM: What I find amazing is the fact that the Portuguese sovereign was upgraded around the same time. It’s an interesting observation, that a bank gets in trouble and yet its state is being upgraded. This shows that the market, as well as the rating agencies, can differentiate.

I’m sure we’ll see more negative surprises causing banks to increase their provisioning, but even with the geopolitical problems, market sentiment still seems positive. You never know what’s around the corner but because you have such extraordinary accommodative monetary policy, even when you look at the Fed which is slowly but surely trying to find an exit from QE, the state of the market is generally very good.

Boehm, Pimco: There are a few broader reasons why covered bonds are as strong as they are. One of the main ones is that they are exempt from bail-in, but despite this, the one outstanding deal issued by BES still underperformed the market as the credit negative developments unfolded. Most of our clients measure our performance against a benchmark, so even if we think the probability of a default of a covered bond is very low, the mark-to-market effect impact on total returns during periods of stress can negatively impact our short term relative performance. Our clients expect us to have foresight to steer clear of such developments.

BES was a friendly reminder how crucial it is to do proper and timely credit analysis while being close enough to the market to identify when securities are fundamentally overvalued or undervalued. In addition to fundamentals, we can frame valuations in the context of relative value versus correlated assets. In the case of BES, relative valuation versus the Portuguese sovereign and comparable periphery sub-investment grade covered bonds were useful indicators to timely identify valuation dislocations.

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