Covered bond spreads must widen — the question is, when?
The European Central Bank will cut its primary market order, but possibly not this year
It seems inevitable that covered bond spreads will widen as the biggest buyer in the market withdraws its presence. The last time that happened was in February 2018, when the ECB began reducing its order from 50% of a deal’s size to just 5% by January 2019.
At that time, spreads widened across the board. French 10 year bonds, for example, moved out by 30bp from around 10bp through mid-swaps to more than 20bp over.
After the last ECB meeting, the market was put on high alert that rates may rise this year, and short term money markets priced in this eventuality.
But before the ECB embarks on raising rates, it will first scale back asset purchases and tighten the terms of its Targeted Long Term Refinancing Operation.
These two interventions (or rather, the removal of intervention) should lead to wider covered bond spreads, not just because the ECB buys less, but also because tighter TLTRO terms stand to make market funding comparatively more palatable for issuers, leading to higher issuance volumes.
Greater issuance and a reduction in demand can mean only one thing: wider spreads. But, as ever, the timing will be somewhat difficult to predict.
Regional variation could also give analysts something to think about. Higher issuance volumes can probably be counted on from banks in northern Europe, but it is far from a foregone conclusion in the south.
Even if the ECB increases the lowest available rate of the TLTRO from minus 100bp to minus 50bp and reduces the duration of funding from three years to two, this is still appreciably cheaper than market funding for many peripheral European issuers. They will probably wait and see what the ECB does to the TLTRO in June before deciding whether or not to return to the market with a covered bond.
And it’s not altogether clear that the ECB will be that quick in cutting its covered bond purchases. The conundrum it faces is that this year’s redemptions from the covered bond purchase programme portfolio are extraordinarily high, at €41bn.
Unless the ECB decides to actively wind down the portfolio, which seems unlikely at this stage, it is committed to at least replacing these bonds, which means it will need to buy at least €3.5bn a month.
And since it will be competing with other investors for an allocation, its order will almost certainly be under-allocated, leaving it short of what it actually needs.
Real investor demand for covered bonds has generally been robust so far this year, partly because the sector offers good value against the sovereign, supranational and agency sectors.
Tuesday’s deals from BPCE and DZ Hyp, which paid in excess of 60bp over Bunds, demonstrate this. Furthermore, most deals are now paying a positive yield and many also offer a pick up to mid-swaps.
With strong competition for bonds expected from real money buyers, it will not be an easy ride for the ECB to maintain the size of its portfolio, let alone grow it. Indeed, despite booming issuance so far this year, its portfolio is smaller than it was in December 2021.
The upshot is that, unless the ECB embarks on a new strategy of winding down its covered bond purchase programme portfolio, it will probably not cut its primary order of 40% of a deal's size too soon.
Notwithstanding that, the balance of demand to supply will inevitably slip further in favour of investors over the course of time.
Next year's covered bond redemptions will be appreciably lower. Moreover, the biggest TLTRO repayments fall due in 2023, and this will put much more pressure on banks to fund in the market.
Accordingly, it seems probable that spreads will widen, but perhaps not until the latter part of this year and next.