Covered bond revival set to run

Covered bonds experienced a year of two halves in 2021, with September and October seeing more issuance than across the whole of the first six months.

Euro benchmark issuance of €42bn in the first half was the weakest for that period since 2009 and down 30% from 2020 H1. But from late August issuance greatly improved, with euro benchmark volumes finishing the year just short of the €94bn chalked up in 2020.

The late jump in supply was largely precipitated by banks outside the eurozone keen to tap the market after their central banks withdrew pandemic-related support that mainly took the form of cheap repo financing.

This was especially the case in Canada, whose borrowers were busy across all currencies and maturities. But in addition, Korean, Australian and Singaporean banks returned across a range of markets — causing global issuance volume to finish the year at €114bn.

The hefty improvement in supply, which caught many market participants by surprise, has given rise to optimism that 2022 will be an even better year. A GlobalCapital survey of 40 bankers taken in October, and therefore before the Omicron variant arrived, suggested that almost half expected euro benchmark volumes to rise by more than 20% in 2022.

“Covered bond volumes will improve,” says Florian Eichert, head of SSA and covered bond research at Crédit Agricole CIB. This is particularly the case in the environmental, social and governance sector, but the increase will “not be enough to prevent a further net shrinkage,” he cautions, referring to the high amount of redemptions due in 2022.

DZ Bank forecasts that gross euro issuance of €122bn in 2022 will be outweighed by €137bn of redemptions, resulting in net negative supply of €15bn. JP Morgan calls for 2022 supply of €145bn across all currencies, this being €36bn below all currency redemptions.

Because net issuance will be negative, “2022 will be a transitional year,” says Matthias Melms, head of syndicate and origination at Helaba. He believes 2023 will be more positive and thinks activity will largely pivot on how the European Central Bank tweaks its Targeted Long Term Refinancing Operations and covered bond purchasing.

The TLTRO provides unbeatable funding, largely through its lowest borrowing rate of minus 100bp. But if that were to rise in 2022, as many expect, issuers would be compelled to turn to the next cheapest source of funding — covered bonds.

On December 16, as this review was going to press, the ECB was due to announce changes to its TLTRO rate.

According to GlobalCapital’s poll, the most favourable TLTRO borrowing rate could end 2022 being hiked by 50bp to match the deposit rate.

Even if issuers do not anticipate an end to the TLTRO, many will want to be “less reliant” on it, says Vincent Hoarau, head of EMEA FIG syndicate at Crédit Agricole. This is especially the case for those in northern Europe who, in contrast to those in the south, were big net users of the TLTRO in 2020.

A big factor behind the expected normalisation of issuance is based on the view that market conditions will get tougher. Not only will TLTRO terms get tighter, leading to increased supply, but the ECB could potentially reduce how much it buys in the primary market.

In 2018 and 2019 the Bank’s decision to scale back the size of its primary market order provided a big impetus for spread widening. “The evolution of spreads will not necessary be a function of gross issuance volumes but may instead depend on when the Eurosystem decides to scale back primary purchases,” says Hoarau.

The ECB had been placing orders of up to 40% of a deal’s size throughout this year, but if it were to begin the journey towards normalising monetary policy, its order stands to be reduced.

On the other hand, 2022’s hefty redemptions also affect the ECB’s covered bond purchase programme (CBPP3) portfolio. As a result, the ECB will need to buy an average of €3.7bn a month in 2022 compared to €2.5bn in 2021 year to replace redeeming deals, according to DZ Bank.

Since all cash redemptions will need to be reinvested in the market to prevent the CBPP3 portfolio from shrinking, a prospective spread widening is likely to prove contained.

Another way to contemplate the spread outlook is to consider the potential for further tightening — which many bankers believe is limited. This was evidenced most lately in October, when BayernLB issued a €500m November 2029. It lost €600m of orders after tightening the spread by 1bp to a re-offer level of 4bp through mid-swaps, this being the equal tightest level of the year.

The deal showed that there is a finite spread, below which investors will not participate, no matter what the credit strength of the issuer is or how rarely it issues. Despite superb market conditions this year, no issuer has managed to pierce minus 4bp the entire year, drawing Helaba’s Melms to the conclusion that the risk of a spread widening has to be greater.

“We’ve had the best market conditions this year, but there’s been very little spread tightening, which rather suggests the market is set up for a widening next year when conditions potentially become less constructive,” he says.

His views are in line with GlobalCapital’s survey which shows a clear majority expect spreads to end wider next year — though there was an almost equal split between those who thought spreads would move out by up to 5bp and those expecting spreads to widen more than 5bp.

Spreads may also be challenged by a potential deterioration in the market’s relative value to other asset classes. This happened in May when covered bond funding in the 15 to 20 year bucket was closed for several months as the market looked too expensive compared with European Union issuance in this tenor.

But in September the ultra-long end re-opened after the EU curve outperformed during the summer, thereby restoring relative value to covered bonds which paid a pick-up of at least 10bp.

It is questionable whether this part of the curve will remain as reliable in 2022 as it was this year. Rising inflation and the prospect that rates could be raised will at times undermine sentiment in the 15-20 year part where investors typically buy on an absolute return basis, making their investments more exposed to rising yields.

Conversely, the five to 10 year area typically attracts buyers focused on the mid-swaps spread, meaning they are less concerned by rising rates. If anything, a higher fixed rate return probably helps — something that the survey bears out.

But for most investors, and especially bank treasury buyers, it is the spread to mid-swaps that plays the critical role in judging fair value, and in this key respect, the market needs to look attractive relative to other asset classes.

The head of covered bonds at DZ Bank, Mathias Ebert, believes relative value judgements could undermine covered bonds again in 2022. “You could see a situation in which there is more sovereign, supranational and agency supply, but less net ECB demand as PEPP is scaled back,” he says.

This would cause SSA paper, which attracts a risk weight of zero, to underperform leading to a narrowing of the differential to covered bonds, which attract a risk weight of 10%. Due to the higher capital charge of covered bonds, bank investors typically seek a pick-up of at least 6bp before committing to covered bond purchases — unlike the ECB which merely needs to reach its target.

In contrast to SSA purchases, the ECB is expected to continue buying covered bonds under its Asset Purchase Programme and, along with high redemptions this could make covered bonds look rich which would “pressure spreads,” says Ebert.

Given these multiple concerns, issuers are expected to take a very different approach to the sequencing of their covered bond funding in 2022 than they did this year.

Rather than wait until after summer, when conditions might potentially get worse, many are likely to be tempted to get ahead of their funding during the first half of 2022. Indeed, the vast majority of respondents polled in this year’s survey agreed with this prognosis.

Strong funding conditions and tight spreads, that prevailed through most of this year in the five to 10 year part of the curve, are expected to carry over into the first part of next year. And with the global economy expected to improve, issuers will have little reason to delay funding plans.

This is particularly pertinent for banks that think they might not be ready to comply with the Covered Bond Directive, which is supposed to be implemented by July 8, 2022. Covered bonds that fail to meet that deadline risk losing their regulatory advantage. Faced with this possibility some borrowers “could be motivated to issue in the first half of 2022,” says Ebert.

Banks that are concerned about prospective deal execution could well turn to environmental, social and governance structures which typically attract a more diverse and larger pool of demand, improving deal execution and performance.

In 2021, 13 banks launched their first ESG covered bonds, taking the total number of ESG issuers to 31. ESG supply rose by €7bn to more than €15bn accounting for about 17% of this year’s total supply.

That’s a number that should grow according to Patrick Seifert, head of primary markets at LBBW.

Seifert says ESG covered bond issuance has the potential to rise to about 25% of annual supply over the medium term — “less than that would be disappointing in my personal opinion”.

ESG deals currently price no more than 1bp tighter than vanilla ones but, in a spread widening environment, this differential would stand to increase, making issuance a more compelling choice for borrowers.

However, others are less optimistic, noting that ESG issuance would need to rise by at least €5bn next year just to keep the proportion steady at 17%.