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FIGCovered Bonds

Where rates go, credit may follow

Volatile exit

The skittish state of investor demand that was recently on display in covered bonds may herald a reassessment of credit, particularly as spreads are back to pre-pandemic levels and seemingly have limited potential for further performance.

The iTraxx Europe Senior Financials and Subordinated Financials indices are both at the tightest levels for the past year. The 49bp difference between them is also at its tightest.

By and large, primary markets still look strong. However, covered bonds experienced a minor hiccup two weeks ago, after one undersubscribed Austrian 20 year offering was followed by several other thinly subscribed issues that were clearly deprived of the depth of demand that was there for earlier deals.

Until mid-May, covered bond issuers had enjoyed an unremitting stream of successes, as borrowers and syndicate bankers basked in the certain knowledge that aggressive European Central Bank purchasing and deeply negative net supply would ensure smooth deal receptions — ad infinitum.

But, as it turned out, relative value considerations came to the fore. In this instance, covered bonds looked particularly vulnerable at the long end, compared with the sovereign, supranational and agency sector. The distinct change in tone might just be a blip, but it could portend more bearish developments elsewhere.

For now, the senior unsecured primary market has barely blinked, with issuers printing deals at tighter and tighter levels. But where covered bonds have gone, senior unsecured may follow.

Perfectly respectable senior deals issued recently by KBC and Belfius lacked the sparkle of earlier trades, leading some to question how much further spreads might go. If the market is not going any tighter and issuers sense that they are up against the limits of demand, it may not be long before investors insist on higher risk premia.

So far this year, the gradual rise in yields has been welcomed by banks, which have seen a commensurate improvement in their net interest margins. And the ECB is not expected to pull the quantitative easing punchbowl away any time soon.

But the unprecedented scale of US fiscal and monetary stimulus should not be overlooked. Despite what the Federal Reserve might say, it is going to be on high alert to any sign of demand-pull inflation.

Tightly priced European fixed income markets may still look like a one-way bet to many, but they are not immune to US contagion. Since the odds of further spread tightening have diminished, it may only be a matter of time before the market becomes susceptible to a more widespread re-evaluation of risk premia.

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