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FIGCovered Bonds

Covered bond market adapts as challenges bite

The European covered bond market has had to adapt to the distorting influence of the European Central Bank’s Covered Bond Purchase Programme (CBPP3), an unsettled outlook for global credit and ever lower yields. But relative value has improved with widening spreads, and real money investors that once deserted the asset class are starting to return. The combination of slightly less central bank buying, higher net issuance and slightly fewer real money investors, for eurozone bonds in particular, is hardly bullish. But buyers are now ready to jump back into covered bonds, as they see value.

Amid volatile sentiment, some issuers are nipping through funding windows. Some, aware of an eventual end to CBPP3, have sought to maximise deal sizes where possible. But given the fickle state of markets, everyone is paying much closer attention to timing, tenor and spread than they have for years.

Investors, meanwhile, have tended to underweight the euro area, as non-eurozone bonds generally offer more attractive returns and better liquidity. That has forced eurozone issuers to raise new issue premiums to some of the highest levels for many years - a welcome counter to low yields and illiquid conditions.

Covered bonds have proved a paragon of stability so far this year, compared with other sectors, with spread widening only moderate.

Price discovery has, on the whole, been straightforward. Syndications that start with initial price thoughts may no longer be warranted for high quality, liquid and frequent names. Yet the initial price iteration can still play a useful role for other issuers, especially because it complies with regulatory standards.

Conditions this year have been rough for certain credits, especially in Italy. But buyers have been able to take a bottom-up approach, making detailed analyses of the cover pools under stressed assumptions and make valuations, even when there is no market. The rewards for this work can be immense, but investors need to be able to upload data into analytics platforms. 

In any case, now that the ECB is the biggest investor it has the responsibility and, more importantly, the power to reactivate liquidity. This could be done at the stroke of a pen, by simply extending covered bond repo terms from a few weeks to several months.

Faced with conflicting variables, investors have strived to come up with an approach that takes account of the many, often opposing, technical and fundamental price drivers. But ultimately it is a fundamental approach that sets the foundation for discerning where true value lies. In a market where price and credit differentials remain distorted, such anomalies present more of an opportunity than a challenge.

Four covered bond issuers, three major investors and the financial institutions syndicate and research heads of covered bonds at Crédit Agricole CIB met in early February to discuss how issuance and investment strategies have adapted to the new market dynamics.

Participants in the roundtable were:

Andreas Denger, portfolio manager and covered bond

analyst, Munich Ergo Asset Management

Florian Eichert, head of covered bond and SSA research, Crédit Agricole CIB

Dominique Heckel, head of long term funding,

La Banque Postale

Vincent Hoarau, head of FIG syndicate, Crédit Agricole CIB

Jörg Huber, head of funding and investor relations,

Landesbank Baden-Württemberg

Hans-Dieter Kemler, head of financial markets, mBank

Kristion Mierau, portfolio manager and head of covered bonds, Pimco

Torsten Strohrmann, covered bond portfolio manager, Deutsche Asset Management

John Arne Wang, head of treasury management, SEB

GlobalCapital: To what extent do you think the European Central Bank’s Covered Bond Purchase Programme has caused real money investors to desert the asset class, and should we be concerned about this?

John Arne Wang, SEB: I don’t think investors have deserted the asset class, but I think the very low, or even negative, yielding environment, combined with the fact that now we’re starting to see increased issuance, could be challenging for the market. The repricing of the primary market that has taken place via increased new issuance premiums, however, should make the value proposition for investors more interesting.

Kristion Mierau, Pimco: To say real money investors have deserted the asset class is a bit of an exaggeration because, in reality, active investors rotate between asset classes. They look at relative value and covered bonds were rich, relative to correlated alternatives. So real money rotated into more liquid asset classes, such as government securities, that weren’t really giving up much yield at the time. But now we’re seeing the opposite scenario, where covered bonds are starting to look cheap relative to alternatives. Whereas last year, it was more about identifying pockets of value, now it’s much broader. There are a lot of opportunities in many segments. Lately we’ve seen wider swap spreads and wider spreads between covered bonds and govvies, so those two things are creating a decent pick-up.

GlobalCapital: Would you agree that investors are returning, on that basis?

Andreas Denger, MEAG: I’d say many real money investors have already left the asset class, and by that I mean they are still invested, but significantly less active in the primary books and secondary market. So the question is when will they return?

We had very tight spreads last year and the market has already started to reprice. But I think a lot of real money investors, including MEAG, are still in ‘wait and see’ mode. You’ve got interesting new issue premiums, but for me these are more a necessary adjustment that helps take the whole market towards new and more tradeable clearing levels than real new issue premiums.

For as long as we see this repricing effect and illiquid conditions, it is probably not the right time for real money investors to go back into covered bonds in a big way. There are some bonds which do comfortably offer long term relative value, but with this repricing it’s probably going to be some time before investors fully return.

Mierau, Pimco: A lot of investors have been on the sidelines for a while now, but in the last few months they’ve started to get involved again. One reason for the buyers’ strike in the fourth quarter of 2015 was the seasonality of supply, as January usually brings the heaviest supply of the year.

In addition to this seasonal pattern, heavy supply in January 2016 was almost a certainty, given high redemptions. Now we’re in the midst of it and things are happening pretty much exactly as expected.

Supply has been heavy and deals have come with decent new issue premiums, which has put further pressure on secondary valuations. This is a very different picture compared with 2015, shortly after CBPP3 launched, when primary new issue premiums were thin and secondary valuations were less influenced by supply.

Torsten Strohrmann, Deutsche Asset Management:  The ECB is trying to do the purchase programme without influencing the market too obviously, by participating more in the primary than the secondary. It’s possibly the least harmful way to do their job, because they can get big sizes and the price is determined more or less by auction. But they still have a crowding out effect.

Investors are not central banks and can’t print money, which means they sometimes have to sell bonds to buy a new issue. But then bank trading books will often get loads of old bonds, which they have difficulty selling, partly because there are fewer investors. This has led to spread widening, which in a way is a healthy development.

Vincent Hoarau, CA-CIB: I don’t believe real money investors have deserted the asset class. Some certainly did, but very few. MEAG, Pimco and DWS are all still active and very supportive to the asset class, they are just more selective in terms of price sensitivity and timing.

Globally, real money accounts are more demanding than ever, given the low absolute coupon level. What we don’t see any more is opportunistic investors from trading or syndicate desks. The average ticket size from real money has decreased in the primary market, which is what you would expect. It’s the same for the overall participation in primary, which has become less systematic.

GlobalCapital: Things have definitely improved, but, let’s face it, the ECB owns a large part of the market and it is getting bigger all the time. That surely means the private sector is being and has been pushed out?

Florian Eichert, CA-CIB: The Covered Bond Purchase Programme (CBPP3) owns €150bn and in total €180bn has been bought under all three programmes. A good chunk of that was bought from private sector investors in the secondary market.

When spreads were at their low point, midway through last year, there was virtually no one but CBPP3 buying. But even after the substantial widening in the second half of 2015, when you look at the distribution of primary deals in early 2016 you can still see central banks have taken over a large portion of demand, especially asset manager demand.

There has thus been a substantial transfer of bonds from the private to the public sector, and at some point CBPP3 could very well own half the market. With a good chunk of the remainder sitting in buy and hold bank treasury accounts, the free float has been, and will continue to be, reduced by the Eurosystem. Reduced liquidity is the biggest problem caused by the purchases. 

GlobalCapital: Is there anything the ECB could do to compensate for the deterioration in liquidity?

Eichert, CA-CIB: As little as I like the Eurosystem intervening in covered bond markets, given their influence and therefore also responsibility, helping improve liquidity by offering long term repos or securities lending should be very high up on their agenda. This will be crucial to keep covered bond investors engaged.

GlobalCapital: Given the recent spread widening, we’ve seen some pretty impressive deals lately. Do you think things might be starting to look up now?

 

Hoarau, CA-CIB: Spread decompression is the new name of the game. With spread differentials increasing between core and non-core and the relative value of the asset class improving, we certainly expect to see more and bigger primary tickets.

The recent Swedbank and SEB five year covered bonds showed clear evidence of improving sentiment at these wider spread levels. Books were much more granular than in the recent past. And both deals attracted the highest oversubscription ratios, with large size, even though the new issue concessions were rather slim.

GlobalCapital: So with spread volatility and low overall yields, are issuers reconsidering their funding strategies?

Jörg Huber, LBBW: Our traditional domestic investor base is still there, but with low yields and spreads they are looking at other asset classes. Demand will come back once we see higher rates, but for the time being it has shrunk. The low yield environment has helped lower our funding costs, but everyone has benefitted and competition for assets remains just as strong. We have not experienced any problem distributing our paper but, as Florian points out, we’ve seen a change in the composition of investors.

Hans-Dieter Kemler, mBank: We are looking at the market constantly, especially with respect to covered bonds. Last year we issued slightly more than the equivalent of Z1.5bn in euro private placements and zloty public bonds. This year we foresee a slightly higher volume, with a shift more towards euros.

One of the main rationales is that euro issuance helps reduce the currency mismatch in our cover pool, a little over half of which is backed by euro commercial real estate assets, along with exclusively zloty residential assets. Euros should offer more achievable volumes of at least €100m, which at a later stage could even be tapped up to a volume that would make them eligible for investors that have minimum volume requirements.

Wang, SEB: We’re also likely to be slightly more active in the euro market, for the fact that, despite all its problems and challenges, it still offers competitive funding, compared with the domestic market at the moment. Added volatility in the Swedish krona market due negative interest rates and quantitative easing means we are considering increasing our funding diversification to reduce execution risk.

Dominique Heckel, La Banque Postale: Issuers have to deal with a volatile market environment and adapt their funding strategies. Market windows open and close, sometimes very quickly, and reactivity becomes key to ensuring a smooth execution. Not surprisingly, competition between new issues is getting tough, putting upward pressure on new issue premiums and requiring more flexibility on maturity and/or size. In our case, we try to adapt our strategy to get the market’s full attention and give a very transparent view on how much we want to issue and at what spread. The pricing position is very important to keep real money investors on board, notwithstanding trying to achieve a competitive spread for the issuer!

GlobalCapital: Can you tell me a little about your ownership and recent funding exercises?

Kemler, mBank: We are a member of the Commerzbank Group, which has a shareholding of around 70%. We have gained some experience in debt capital markets, having placed four senior unsecured deals, three in euros and one in Swiss francs. We enjoy a covered bond market share of roughly 75% in Poland and have worked closely with investors in Germany and Austria, where we can definitely confirm there is appetite for Polish risk, currently more in covered bond format than in senior. We’ve placed roughly 10 deals as private placements, which has helped improve our name recognition and investors’ familiarity with our product.

What’s constrained us so far is the size we can print, which given the extent of our cover pool, does not justify a €500m benchmark. But we hope the overall market will benefit from having more players, such as PKO Bank Hipoteczny, which is likely to show up this year with a meaningful covered bond placement into western Europe. And given the proximity of Germany to Poland and our shareholder structure, we should benefit from name recognition, especially with German-speaking investors.

GlobalCapital: How would your bonds be treated in terms of rating, risk weights, liquidity coverage ratio (LCR) and repo eligibility?

Kemler, mBank: Our covered bonds are currently rated BBB on positive watch with Fitch. Given the structural soundness of the newly amended legislation, where you have mandatory overcollateralisation of 10%, I would expect them to land in the single-A category, but we’ll have to wait and see. To the extent we can reach €250m or above, it will be LCR-eligible. And with respect to repo we have yet to find out, but would expect so. However, the bonds wouldn’t be eligible for CBPP3, which is actually helpful because it means we should be able to issue with a spread that’s attractive to investors in western Europe — as well as to us.

GlobalCapital: Aside from mandatory OC, what would you say were the top three changes to legislation?

Kemler, mBank: The elimination of withholding tax on interest payments to foreign investors, a switch to soft bullet and potentially a conditional pass-through following an issuer’s insolvency, and a mandatory liquidity buffer covering six months of outgoings.

GlobalCapital: Can you tell me about LBBW’s approach the market?

Huber, LBBW: It’s not possible to market a deal for a week or two. You have to be really proactive and use windows when they are open. We saw last year that funding windows can close for a couple of weeks or more, and then they open for a day or two before shutting again, and we’ve already experienced that this year.

GlobalCapital: To what extent do market conditions dictate the choice of tenor?

Huber, LBBW: It’s really important to bring the right maturities at the right time. At the beginning of this year we were thinking about issuing a seven year but the window was better for a four year, which we did instead. But at the moment, we couldn’t do a four year. Even a five year might be a stretch, given nobody is buying primary covered bonds at negative yields. 2015 was a difficult year, but I think it’s going to be the same this year too.

Hoarau, CA-CIB: The market is up and down every day, and as Jörg says, when there’s a window you have to catch it. But it’s clear strong names have access to covered bond funding at almost any time.

Though in general, for many names, issuers have to be prepared to pull the trigger as soon as the market is there and when people are likely to be most receptive to your trade. So, yes, issuers need to be proactive, on the road continually, and lined up with the correct documentation to ensure they are ready to move at any time. Nevertheless, it has been pretty evident that recent deal executions have demonstrated the strong resilience of the asset class. It was clearly identifiable as the only safe bet, at a time when higher beta capital market instruments had capitulated. So, to temper my previous comment: strong names have access to funding in covered format at almost any time.

GlobalCapital: In light of the negative technical factors, should investors come to the market early?

Huber, LBBW: We certainly see that at the moment. Markets are good and we try to issue. I would really act as soon as windows are open in certain maturities. If there’s an opportunity there and I can issue, I will rather do it than try and spread my funding over the whole year. But I wouldn’t say we have a strategy to do everything in the first half of the year.

Wang, SEB: Given market uncertainty and the outlook for supply, which may be more than we have seen for some time, we have taken a more progressive approach. We have to be more agile with our funding strategies. So if the market is functioning well, it will probably take somewhat more volume earlier in the year. From that perspective, some frontloading will probably take place, even though our overall funding plans have not changed significantly.

Heckel, Banque Postale: An anticipated slowdown in CBPP3 buying could push some issuers to frontload part of their funding. For our part, the timing of issues is more linked to our commercial activities. Anyhow, recent comments from the ECB suggest that CBPP3 tapering is not on the 2016 agenda.

GlobalCapital: Florian, there’s talk of CBPP3 perhaps getting wound down in favour of the Public Sector Purchase Programme (PSPP). We’re already seeing less purchasing in the secondary market. Do you get the feeling that the ECB is taking its foot off the accelerator, as a prelude to phasing its buying out?

Eichert, CA-CIB: The overall rate of buying is coming down compared with 2015, but that’s a long, long way away from saying that they’re phasing CBPP3 out. I’ve had a lot of meetings with various national central banks ever since we started marketing our 2016 outlook at the end of November. And the feeling I got was that a phasing out is not on the cards. And we heard the ECB saying at a conference last week that they were not going to prematurely quit, but would continue buying until the end of the overall QE programme.

I know some analysts have written about CBPP3 being phased out, but the ECB doesn’t have the luxury of being able to do so, in my view. It is true PSPP has given them larger volumes, but at some point they might find it harder to source public sector assets as well, so they will want to keep all options open. They increased the volumes bought under the PSPP towards the end of last year, but in my view that was mainly because they actively wanted the covered bond market to reprice.

GlobalCapital: So you’re saying the ECB executed a deliberate strategy to widen spreads?

Eichert, CA-CIB: They themselves had realised that at those spread levels there was no one willing to engage. And the Eurosystem does need a functioning primary market to successfully reach its buying target for covered bonds. Hence they temporarily stepped back and let the market reprice. Secondary purchase volumes have clearly not been in the €400m-€500m a day range any more, but even with active primary markets like we had last week, they were still in for about €200m a day in the secondary market. So yes, CBPP3 is running at a lower volume, but I don’t see them stopping any time soon.

Huber, LBBW:  We’ve seen a real change of attitude in the behaviour of CBPP3 in the primary market, as they now tend to be much more like a normal investor. Central banks now put very intentional spread limits when they get engaged in the primary market. They are getting more picky and annoyed when syndicates or issuers try to push the spread a bit too far. This change of attitude is very healthy — we want them to behave more like a normal investor.

Strohrmann, Deutsche AM: Non-eurozone euro benchmarks seem to price more on real investor demand, so they give a better view on clearing levels, but they are also influenced heavily by CBPP3. It seems everyone is benefitting from the programme, which means that when the programme eventually stops these markets are also going to get hit, but probably not to the same degree as CBPP3-eligible bonds.

Kemler, mBank: From our perspective, being ineligible for CBPP3 has two major benefits. First, we will not be tempted to grow our balance sheet with assets that we would otherwise not take on board. And secondly, we can try to attract some of those natural buyers that have been “crowded out” and which still have funds to invest in an issuer with a sound risk profile and a healthy spread.

GlobalCapital: Do you think the market is now starting to price for the ECB’s eventual exit from CBPP3?

Mierau, Pimco: I think the ECB exiting in 2016 is, to some extent, already priced in. The recent shift in the CBPP3 modus operandi to more of a focus on primary has had a significant impact by putting less of a footprint on secondary valuations, so to speak.

In other words, the demand for covered bonds driven by moral hazard has dissipated as investors and the street no longer can rely on the ECB to be a backstop bid in the secondary market.

What the ECB’s strong participation in primary markets has done is basically keep cheap funding open across the credit spectrum. Thus, if CBPP3 were to end tomorrow, I would expect the impact to be most felt by weaker names, as their access to primary would be threatened, which obviously has negative implications for valuations of their bonds.

GlobalCapital: What’s your view on the price discovery process, setting initial price thoughts, guidance, refined guidance, and so on?

Huber, LBBW:  I don’t really like to put out a large carrot when I know it will end up being a much smaller carrot. As I understand International Capital Market Association rules, it’s not possible to have price whispers any longer, as you really need to get all investors involved to begin with. That means we have to go with the way we are doing it now, even though I would rather go out with some confidence that I have the right spread, give or take 1bp or 2bp. These are the rules, so this is how it has to be. But I found in earlier times that it was a much more pleasant process, as you knew exactly where you would end up. But I guess with the way things are nowadays there is a kind of limited price range where you are going to print a deal.

Denger, MEAG: I don’t like to see deals price far inside initial price thoughts. Sometimes you really feel like you’re getting fooled when the deal ends up being priced far away from IPTs. So maybe the question is — what is a successful deal? It may not always be the one with the biggest order book, which as Jörg said, fails to deliver the large carrot.

Hoarau, CA-CIB: If I remember correctly, IPTs were initiated during the darkest days of the crisis when secondary market liquidity was non-existent and liquidity in primary was extremely limited. As price discovery was fairly challenging, having IPTs helped reduce uncertainty.

But today we more or less know where fair value is in the secondary market, and from there it’s possible get to the right price, depending on where you set the new issue premium. I really don’t see a great need for IPTs these days and I hope we see a normalisation, as this would clearly be less annoying for investors. But this means syndicates will have to approach investors at a price which is closer to where they want to finish.

GlobalCapital: Looking at the overall dynamics of the market, we are seeing less central bank buying, supply will change from net negative to net positive, we’ve got fewer real money investors in the asset class, and to add to all that, liquidity is virtually non-existent. Don’t these factors pose a dangerous cocktail?

Strohrmann, Deutsche AM: Well, it’s the cocktail we get right now! We have to deal with it, but it’s not a big problem. The spread widening is mild, supply is positive, but issuers are not flooding the market. We are not in a critical situation. I don’t know if more investors will leave the market, but even if they do we can deal with that. It’s not like spreads are back to 600bp or 200bp on the index. We are in a more normal market environment where spreads are simply breathing a bit. We have no fundamental problems with the market. This is more of a technical issue we are facing. The balance of supply and demand is going to be distorted if you have such a big buyer. Given that the ECB already own a quarter of the market, I’d say they are doing a pretty good job.

Heckel, Banque Postale: Those elements you mention are definitely a concern for the covered bond market. More generally, the global yield environment, especially for low return asset classes, is a game changer and both issuers and investors will have to deal with it. One could hope that the ECB will carefully manage the tapering. Pressure on spreads is already in place and could continue, but this might also increase relative value to other asset classes, especially SSAs, and bring real money investors back to our proven high quality asset class.

Mierau, Pimco: Sure, the technical backdrop isn’t as friendly as it used to be. But there’s already been a substantial decompression between CBPP3-eligible and non-eligible bonds in recent months. I don’t know if that trade still has legs. French covered bonds, for example, are now trading within a few basis points of Swedish and UK covered bonds, although some French names arguably should trade wider to many of their peers. I’d like to think the changing dynamics of the market will get investors back to basics where they again differentiate based on fundamentals.

Eichert, CA-CIB: I wouldn’t paint too dramatic a picture here. Yes, the Eurosystem has slowed down its purchasing somewhat, but they are not going anywhere. In fact, if you consider them reinvesting maturities, we will have annual covered bond buying of roughly €40bn-€50bn a year, even once QE ends. And for net supply, yes, it has turned positive. But if you factor in central bank buying, net supply for private sector investors is still deeply negative. And for private investors leaving, bank treasuries are still very active, and if the ECB can help liquidity by offering long term repos (and we’re not talking a week or two, but ideally a few months), liquidity should improve and asset managers should return, or at least not reduce holdings further.

GlobalCapital: Will eurozone issuers be at a disadvantage when CBPP3 is tapered and artificially tight secondary spreads normalise?

Heckel, Banque Postale: Normalisation has already started, due to the change in the ECB’s practice in buying covered bonds, with a greater focus on the primary market. There is still some room to reach equilibrium. For now, the differential is still in favour of non-eurozone issuers and their attractiveness is highlighted by the order books of their new issues. But the gradual compression of the spread differential between CBPP3-eligible and non-eligible jurisdictions should bring back some relative value to eurozone issuers and restore investor demand for them.

Wang, SEB: I’m concerned about the cocktail of all these factors working in unison. You have low government yields, tight swap spreads, excess liquidity and negative interest rates. That in itself, over time, is damaging for covered bonds or any product which is relatively low yielding. That probably worries me more than some of the other things, meaning that in general it becomes more difficult to access the markets, or you just have to be much more careful in the way you work the market.

 

GlobalCapital: If there’s less liquidity, there will be fewer people wanting to get involved, and that creates a negative feedback loop. Andreas, do you think this has contributed to this year’s repricing?

Denger, MEAG: Poor liquidity is a huge driver of the current repricing, which is something we saw in the sovereign crisis. You’ve got a huge amount of primary issuance, the secondary market getting repriced and shrinking bank balance sheets.

Some banks have simply disappeared and it’s very hard to sell bigger volumes. There’s no possibility to hedge positions and you don’t know what’s going to happen next. Take Monte dei Paschi, for example. Its covered bonds were recently heavily repriced. If you’ve got an investor who makes a decision to sell these bonds they’re going to reprice the market heavily. So then we need to find a new price equilibrium where we can say, OK, that is where I can take these bonds on my book and I won’t expect an immediate repricing. At that point liquidity should come back.

Mierau, Pimco: Liquidity was broadly underpriced in the market, not just in covereds. If you look at KfW versus more liquid German Bunds for example, during 2015, the two issuers converged within a few basis points. When there’s too much cash in the system, investors simply become price takers. At least in covereds, liquidity premiums have increased considerably, which, together with increasingly attractive relative valuations, is inspiring some investors to come back to the asset class.

Strohrmann, Deutsche AM: Liquidity is very poor at the moment and spreads are also still a little bit too low to make up for this lack of liquidity, but we have to deal with it. So as an investor, when you want to sell you can expect very bad prices. It’s therefore important to try and get higher rates in new issues to compensate for this lack of liquidity. But a higher rate of return is something that’s not so easy to find. The number of market makers are falling, their trading books are smaller and there are fewer investors, so liquidity can only become more and more diminished. There’s no easy solution to this problem.

Denger, MEAG: One important point for me is the indiscriminate nature of CBPP3 buying, which takes no account of the real fundamentals. This makes it hard for us to put on relative value trades. For example, if we have two names and one is fundamentally much better and it’s maybe mispriced, in the past you could confidently set up a relative value trade. But with CBPP3, the weaker name gets bought too, which destroys relative value and is of course not healthy.

Wang, SEB: CBPP3 has impacted the marketplace quite negatively with its systematic buying, so that means normal price discovery is not really functioning well. And then of course liquidity has been hit by the tide of regulations, which means appetite to hold trading inventory has declined significantly. Those two factors combined means it’s much harder for investors to see where exactly secondary markets are. The question then is — are secondary levels really a good benchmark for any issuance? This increased uncertainty means investors demand higher new issuance premiums, so I can understand where they’re coming from.

From our point of view, this means we have to be somewhat more careful about the timing of a transaction as, even if we have a stable market, you often see different pricing levels for the same bond.

Part of the reason is that certain counterparties have become less active. Bank treasuries, for instance, are heavily invested in covered bonds, which means they’re not expanding at the same pace any longer.

There are a few groups of investors who have become less aggressive. The market has been in such an abnormal place for a while, and it may take some time to find a new equilibrium.

Eichert, CA-CIB: As I mentioned earlier, I do believe the ECB can and will do something about liquidity.

They can already lend the securities they have purchased for their QE portfolios, only I don’t know anyone that has ever used this. Until now, the modalities were just simply not well known, with every central bank having their own approach and pricing. If the Eurosystem were to harmonise this, make it more transparent and lend for not only a week or two but for one, two or even three months I believe people would make use of it, and that in turn should improve secondary market liquidity.

Similar to them letting the market reprice to create an active primary, this is in their interest, as it will help them to keep up purchases.

GlobalCapital: Which markets offer the best liquidity? Is Germany still the leader?

Mierau, Pimco: In some of the Nordic names, liquidity has remained rather good because they have a steady primary supply and Nordic banks use covered bonds a lot for funding. So they have a lot of deals of one billion or more. On the other hand, it’s very difficult to source German paper due to the supply shortage, strong domestic investor base and smaller deal sizes, where half goes to CBPP3.

GlobalCapital: Do you have a sort of liquidity ranking scale that you think about when you look at new issue premiums?

Mierau, Pimco: Absolutely. Maybe not a ranking scale, but we do have a fairly objective methodology. We consider liquidity a risk attribute, which we make best efforts to quantify on a continuous basis. You could think of it as the compensation you get which reflects your desired holding period and the costs of making an eventual “round trip”, in the unlikely case that we were to become a forced seller. 

So, just as I would expect a term premium for a bond with a longer tenor, I would want more compensation for a bond that is less liquid. Whether it be a primary deal or a seller coming to us in the secondary market with an offer of a large block of bonds, our bid would include a discount for liquidity conditions such as bid-ask spread, market depth, and float of bonds with similar characteristics. Just like the Street expects compensation for making markets using their balance sheet, we expect compensation for providing liquidity with our balance sheet. 

GlobalCapital: In Italy, volatility has really hit equities and subordinated debt, but if you are approaching covered bonds from a fundamental perspective and looking at the collateral and pay-down structure, then presumably there are some positive factors in terms of the quality of the assets and timely payment. How confident can we actually be?

Eichert CA-CIB: These Italian pools are good quality. If you look at some of the rating agency metrics or look at the underlying certifications, they have the same asset quality as issuers in core Europe. The problem is pool analysis comes at a fairly late stage in the investment process for many investors. When you had these bonds trading at cash prices of 75-76 it did make sense to run recovery scenarios, as you could run the analysis and expect maybe 85-90. But because overall yields are so low, current cash prices are often above par, even for more distressed bonds. So unless a weak name happens to have a long dated covered bond outstanding, in most cases you can’t really base a trade on this approach these days.

The more immediate concern and spread driver is how troubled banks are going to be resolved. Look at Kommunalkredit, where the cover pool was pretty good, but when it came to resolution the pool was split and some parts were moved to a new entity owned by private equity investors. This is the stuff that drives spreads, particularly given the low level of liquidity.

GlobalCapital: We’ve seen recent deals from weaker Italian banks issued last year and it feels like there may be more distress to come. Is there a case for buying some of this stuff and putting it away into some sort of buy and hold account where the mark to market risk is a bit less painful?

Hoarau, CA-CIB: The repricing has already taken place, but there’s certainly room for further decompression versus stronger peers. But there are clearly opportunities for long term real money investment, despite the impact of CBPP3 and the Eurosystem. The success of the longer dated peripheral primary deals in the fourth quarter last year clearly shows that there is appetite for such credits.

Strohrmann, Deutsche AM: From a collateral, structural and legal point of view I think Italy is quite strong, but we have some weak banks. So we have to judge the probability of problems arising, which is obviously higher for these weaker names.

But in the end, I don’t believe this will have a big impact on covered bonds. We’ve already seen significant spread widening in Italy and the market is still in the process of finding value. But at least we now have a solution which the Commission has endorsed, that should prevent a meltdown due to rising non-performing loans. It’s quite important for the market to have the assurance that these problems are finally being dealt with, and this should ultimately lead to a better performance. Longer term, there’s a chance of an improvement in Italy’s mortgage lending, which is also quite positive.

Mierau, Pimco: The Italian banking sector non-performing loan story is not going to go away overnight. The recent guarantee scheme is not the silver bullet the market was hoping for, thus there will inevitably be more developments. At least with respect to covered bonds, investors can be comforted by the fact that the cover pools don’t suffer the same asset quality and loan performance problems as broader bank balance sheets.

GlobalCapital: When the market’s really in a difficult situation, how do you value this stuff and what is the importance of transparency?

Mierau, Pimco: If you don’t have the transparency to do the credit work, then it’s difficult to assess the premium we would pay over unsecured debt from the respective issuer. On the other hand, if there is adequate transparency, we can evaluate the credit quality of the covered bond programme on a standalone basis. Using quantitative finance techniques, we can assess fair value by comparing simulated loss severities to expected recoveries in comparable RMBS or unsecured debt of the same issuer, scaled by default probabilities. So transparency is paramount, particularly in the current situation with Italian covered bonds.

GlobalCapital: So with this bottom-up analysis, you are able to come up with a bid, when potentially there is no bid in the Street?

Mierau, Pimco: Yes, valuations would thus reflect a hold to maturity orientation.

GlobalCapital: We’ve talked about the bottom-up approach, and maybe the top-down approach works for higher rated names and countries.

At the same time, there are all these slightly negative factors like liquidity, the net positive supply and CBPP3 stepping back a bit. On the other hand are strong positive factors like banks building up their capital buffers and ratings moving in the right direction. Investors are faced with an immense amount of information and many variables pulling in different directions. So how do you come up with a logical covered bond investment methodology?

Denger, MEAG: If you have another two hours I can explain our investment approach! But making it shorter, there is no one-size-fits-all recipe. Your approach depends on the country, the issuer and the assets. Fundamentals are a long term determining factor, but when you’re trying to put on a short term relative value trade, technical factors like liquidity become critical.

There are some bonds currently trading at very wide levels which have repriced maybe a little bit too much, so even if you see a bit more widening you should end up doing quite well. On the other hand, you need to position yourself for new issues. Jörg and Vincent mentioned that some maturities are more in focus than others due to the current environment, so maybe you can put on relative value trades that take account of these conditions. The approach needs to be adjusted to the circumstances and market conditions.

Strohrmann, Deutsche AM: We have three fundamental elements we take a view on: the bank itself, the collateral pool and the legislation.

Nevertheless, we have to admit that right now, the fundamentals don’t play a big role in the market, as it seems technical issues are dominating. We keep on going with the fundamental path and try to avoid any pitfalls.

Since liquidity is a big issue we always go for benchmark deals. Nevertheless, technicals play the more important role, which means there’s not much spread differentiation and it’s difficult to put on relative value plays owing to poor liquidity. But technical issues can only be a reason to act tactically.

GlobalCapital: Commonwealth Bank of Australia recently priced a five year at almost seven times the spread paid by BNP Paribas, a lower rated bank. So I guess these technical distortions can throw up some good investment opportunities.    

Strohrmann, Deutsche AM:  I’m a natural investor in non-eurozone bonds. So in our fundamental approach we also take account of the spread. But every country has some risks. You mentioned Australia: in this case we have collapsing commodity prices and weaker Chinese growth, which is obviously going to affect the economy.

So we take this into consideration using the fundamental approach, and then we have to judge if there’s enough spread. It’s hard to compare between issuers in the EU, eurozone and non-EU because due to technical factors they can’t have the same spreads, there have to be differences.

GlobalCapital: Florian, what are you seeing from your discussions with investors?

Eichert, CA-CIB:  Well, the strategy or the way to approach covered bonds differs by investor type.

You have bank treasuries, for which a big enough spread over zero risk-weighted assets is what is needed. Liquidity to those accounts isn’t as big an issue, as they are mainly buy-and-hold investors focused on stable carry. They have focused a lot on highly rated, EEA but CBPP3 non-eligible bonds, such as new issues from DNB or Lloyds.

On the asset management side, investors first of all need to be comfortable enough with the ECB impact going forward and lower liquidity in eligible markets. If they expect a premature exit, the strategy is probably to invest elsewhere and wait for covered bonds to widen even more, irrespective of the sector or issuer.

For those confident enough about the ongoing QE impact, trying to focus on fundamental quality and profiting from the distortions it has created is the way to go. In some cases, this might mean buying strong non-eligible names that offer additional pick-up. Or within the eligible universe, it could mean moving into the best quality issuers without giving up much yield.

And for the most aggressive investors, there are some distressed candidates where you can probably go bottom-up and start from the cover pool.

Huber, LBBW: Our investment decision takes account of two variables that no one has so far mentioned. What is the issuer’s funding requirement and frequency of appearance in the primary market, and what is their track record in terms of their approach to pricing? This is of course a bit subjective, but I believe these factors should be taken into consideration when it comes to assessing relative performance between deals.

GlobalCapital: Do you think there is scope for new issue premiums to tighten a bit, given that spreads have now widened quite a way?

Huber, LBBW: If spreads start to normalise, I guess investor demand will come back. And since wider spreads should also give more comfort, you might also see some kind of compression of new issue premiums. But that’s a long shot and I wouldn’t expect that to happen soon.

GlobalCapital: How do you view the whole dynamic between new issue concessions and where spreads are going?

Hoarau, CA-CIB:  January’s risk-averse environment is here to stay, so to me, new issue premiums are set to remain high, at least during the first quarter.

The global macroeconomic environment is far from rosy and this may become even more exacerbated further into 2016, which will add complexity and make investor sentiment more volatile. I don’t see really what can drive spreads or issue premiums tighter in the near term, unless the macroeconomic data delivers a strong upturn and yields rise again. It is possible blackout periods will lower primary activity and support spreads, but I am not so sure, given the number of risk factors.

Strohrmann, Deutsche AM: If investors continue to leave this market, concessions will have to grow. On the other hand, if CBPP3 is expanded and the ECB buys even more in the primary market, then of course issuers can force spreads tighter. But my expectation is that primary new issue concessions will cause the secondary market to widen. And if a lot of supply comes, the secondary market widening may lead to further widening in the primary.

Wang, SEB: In the short to medium term it’s hard to see the situation changing, given the uncertainty over where secondary deals are trading and given illiquidity. We’ve seen very volatile credit markets and people are pretty uncertain about what exactly the ECB is going to do. It’s obviously very important to have a sense of what its next steps will be. On the other hand, the ECB still pretty much buys 50% of everything, so I think people sometimes get a bit too carried away with their negative assessments. But in general, the market environment points to relatively high new issue premiums for a while longer.

GlobalCapital: As an issuer outside the eurozone, are you hopeful that your curve will not widen as much as CBPP3-eligible deals?

Wang, SEB:  It is logical that this should happen. I think we’re now in a period where some investors may be buying bonds without properly assessing the credit risk. In 2014/2015, the market basically absorbed a lot of paper, seemingly irrespective of underlying credit metrics. But it could take some time, given that secondary markets are completely hampered. I would imagine new issue premiums for CBPP3-eligible issuers could widen by a greater degree, given that secondary levels will not reflect where investors will want to buy. But there again, the ECB had said it would stop in September this year and then in December they extended the programme to March next year. So they could easily go on longer, no one really knows. What I’m afraid of is that we will all be dragged into wider territory. We all benefitted when the ECB came in, so the risk is that we all might be dragged wider when they really do start tapering.

GlobalCapital: Is the market correctly pricing for the extension risks between hard and soft bullets, and conditional passthroughs?

Denger, MEAG: With a normal soft bullet that has a six months or one year extension, there does need to be some price differentiation. A soft bullet is a good protection mechanism to avoid a cross-default of all covered bonds in the event of an issuer’s default.

With conditional passthrough, it’s different. They can all be structured differently so each different structure needs much more detailed analysis. You really need to understand the trigger thresholds as well as the cash flows. We have heard it already with Monte dei Paschi. If the passthrough has been triggered, you really need much more transparency to evaluate the pool. There’s a good reason why CPTs should trade at a premium.

On the other hand, having a double-A or triple-A rating is more and more important when it comes to regulations. So even though it sounds strange, it could be that a triple-A rated CPT is a better choice of investment for some ratings-dependent investors than a fundamentally better hard bullet bond that only gets a rating between single-A and double-A. Given the importance of ratings in driving spreads, I don’t know if a premium for a CPT can actually be achieved. And with CBPP3 buying everything, there is less chance to differentiate on price.

GlobalCapital: Given the impact of time subordination, which should in theory lead to a lower recovery on a bullet bond, would you prefer to own a long-dated conditional passthrough from a weak issuer or a long-dated soft bullet from an equally weak issuer?

Strohrmann, Deutsche AM: In most cases I think investors would be unhappy with a passthrough security, they would rather go for a hard bullet and be sure that there is sufficient collateral in the pool to redeem the notes in full when they’re due. Visibility is better at the short end, but if you’re wrong and invested in a passthrough then you could be waiting a long, long time, so we try to avoid weak names.

Mierau, Pimco: Since we’ve never seen a default in covered bonds, we don’t have any precedents of what recoveries will be between these different structures. And the fact that most of these features only trigger when there’s a default makes it increasingly difficult to quantify the option value of these features versus traditional hard bullets.

GlobalCapital: We’ve had a lot of consent solicitations recently. Do you think the flat fees being paid on all types of credit have been appropriate?

Strohrmann, Deutsche AM: I think that everybody paying five cents is somehow not reflecting the real risks. But since investors are accepting this, issuers continue to pay only that and no more. In theory there should be a correlation between the strength of a bank and the premium they pay for switching from hard to soft bullet. As I said earlier, the probability of problems is greater, the weaker the bank is, and this means there is a higher chance the maturity will be extended.

Denger, MEAG: There’s a good argument for getting a higher fee in some cases. However, we would need to have strong arguments. One might be if the ECB, as a big covered bond holder, decided to play a more active role in consent solicitations.

GlobalCapital: It seems some issuers have been taking investors for a ride when it comes to contractual changes in documentation. What do you feel about that?

Denger, MEAG: We had it with Banco Popolare, where implemented changes were very strange. There was a first round which didn’t get a quorum. Then there was a second round, which not all investors, it seemed, were properly informed about, and which maybe only a few investors took part in. In the end, the issuer got the approval to change documentation, even though it wasn’t in the best interest of investors. We feel that in the future the whole process of contractual changes needs to be much more transparent and more strictly regulated.

GlobalCapital: I understand that the ECB has so far not participated in consent solicitations, which is probably why some issuers have been able to get way with making binding decisions based on the approval of a minority of noteholders. Since the ECB owns most of the market, do you think they might actually start to take a more proactive approach and help the rest of the market?   

Eichert, CA-CIB: I believe they were quite actively thinking about what to do, and I understand they have been quite unhappy about some of the processes taken by issuers. They have criticised quite a few elements of the consent solicitations that have taken place so far.

GlobalCapital: It was good to see that the ECB made an official stand on this point in its response to the European Commission’s consultation on covered bond harmonisation.

Eichert, CA-CIB: Given that they will own a big chunk of the market, they are aware of their responsibility when it comes situations like this. I believe they are trying to come up with their own policy on how to act in consent solicitations.

Mierau, Pimco: If you can’t quantify the difference from a recovery or extension risk standpoint, then it’s pretty difficult to say what fair compensation is.

GlobalCapital: So you take the five cents and move on?

Mierau, Pimco: Pretty much. But five cents is usually immaterial in any case, especially for longer tenor bonds where it’s not even a basis point.

GlobalCapital: Would you ever consider buying with a negative yield?

Denger, MEAG: Technically, we can buy negative yields, and we know of course we have got negative yields in the government space. Let’s assume we have got covered bonds with a negative yield, but less negative than other asset classes. Clearly it can make sense if you are a benchmark investor. You also have a negative interest rate on cash accounts, which is getting higher and higher. So a covered bond with a low negative yield can be an investment which makes sense. It also makes sense to park some of your bonds at the liquid short end with a negative yield because you cannot always go fully long duration and long risk.

Heckel, Banque Postale: It seems quite possible to have a deal with a negative yield, obviously in the short end of the curve, given the current ECB rate policy expectations. In this situation, demand from bank treasuries could support order books, as they will focus more on the bond maturity and spread rather than absolute yield. But market depth for such issues could be limited.

Mierau, Pimco: In a perfect world, no rational investor would invest in anything with a negative yield. But in reality, everything is relative, so the decision is dependent on what the alternatives are. If you let your cash go uninvested and your custodian charges you, say, 30bp, then you have a pretty strong incentive to invest in liquid securities at a less negative yield.

Wang, SEB: Negative rates are not necessarily an absolute show-stopper, but combined with relatively tight spreads, which are impacted by the fact that there’s too much excess liquidity in the market, it means investors simply do not buy at the old original spreads. The risk is that spreads will continue to widen, if rates go more negative.

So from an issuer’s point of view, as long as we are able to transfer the higher cost of funding out to our clients, it’s manageable. It’s more the functioning of the markets I’m worried about. The spread widening as such, if not too significant, I’m not necessarily that worried about. In fact, recent spread widening has probably had a positive impact in bringing investors back to the table.

GlobalCapital: Do you think the incentive to hold a slightly negatively yielding covered bond is growing?   

Eichert, CA-CIB: A high proportion of the short end of the covered bond market is trading in negative yield territory, though in most cases only by a few basis points. At the same time, managers pretty much across the board are getting charged for holding cash, even those that are part of banking groups and can park cash with their parent company. And with two year Bunds inside a -0.5% yield, I’ve come across more and more asset managers and money market funds that want to look at shorter dated covereds as a higher yielding, but very stable and highly rated, alternative. The same holds true for bank treasuries’ liquidity portfolios. The incentive to own negative yielding covered bonds is there. In any case, what’s a negative yield? At the end of the day it’s just a few basis points less than positive!

GlobalCapital: Does that mean we are ready to see a negative yielding primary deal?

Hoarau, CA-CIB: I seriously doubt that the market is prepared to accept a negative yielding primary deal. Negative spreads are mainly limited to the one and two year part of the curve in the secondary market. Buyers so far are mainly central banks and bank treasuries. I can’t imagine you can really build a primary book with this. In fact, we are starting to see some rates investors increasing their exposure to covered bonds, as the portion of SSA paper in negative territory increases.

Strohrmann, Deutsche AM: Investors in our funds expect us to have as good performance as possible, so buying with negative yield doesn’t help. But if a bond is bought and then the yield goes negative, that’s a different matter. In any case you still have some opportunities to get a positive yield, even in the short end, so we are not yet that desperate. 

GlobalCapital: What’s your view on new markets such as Singapore, Korea, Turkey and Poland?

Strohrmann, Deutsche AM: I’m excited to see these new markets. It’s good to see Korean covered bonds in dollars. But we try to avoid getting in early. Typically, when you have a new legal framework there can be a lot of renewal in the first year or two, because maybe some things are not compatible with insolvency law, for example. But after a while you might see things stabilising a bit and that’s really the point where it starts to get interesting for us.

Denger, MEAG: If market conditions and spreads are right, we wouldn’t rule out buying them, but they need to work. For example, the Singapore deal in dollars was quite expensive and what we heard from our guys covering Turkey, in terms of their spread ideas, they were much too tight. So if the spread is OK and we are happy with the country on the fundamentals, we wouldn’t rule it out. So far, we haven’t seen a really good investment alternative and we haven’t been active in those markets.

Mierau, Pimco: New markets are a positive development. Australia is a good example of opportunities presented by new entrants to the asset class. When Australia came to the covered bond market, there was a feeling-out process for investor appetite. There was a first mover advantage for investors that were involved early on. This process of price discovery is typical when new entrants join the market.

GlobalCapital: What about Poland — that’s closer to home?

Denger, MEAG: You need to value them compared with covered bond peers which are already out with deals, and you need to look at where spreads are in euros and local currency terms to come up with a relative value idea. If the result of our analysis is that there is good value, then, yes, of course we would consider investing.

Strohrmann, Deutsche AM: Poland is not really in the same boat as Singapore or Korea because the law is older and you’ve seen issuance. People are assessing the amended law, but overall, what we need to see are benchmarks. For us, private placements are much more illiquid.

GlobalCapital: I assume sub-benchmark size at issuance means your bonds will lack liquidity, though on the other hand, investors will be compensated.

Kemler, mBank: In my view, this assumption of liquidity or even market-making, for even benchmark-sized bonds, is an illusion. If anyone thinks that in a distressed market environment they will get a price in even €5m size, they will be deeply disappointed. But as far as our bonds are concerned, if you place something with an initial issue size of, say, €150m, the likelihood that there is anything like a liquid market, even two weeks after the issue has settled, is probably far-fetched, but to some extent that will be reflected in the spread.

GlobalCapital: This year, macroeconomic themes, such as slowing Chinese growth and falling oil prices, have caused a correction in risk assets. How do you think the changing economic environment will affect covered bonds in the long run?

Heckel, Banque Postale: The past weeks and months have proved that volatility is back and that macro themes will bring uncertainty for all market participants. Covered bonds are still a low risk investment and therefore they should be able to keep investors’ attention.  

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