Peripheral European issuers need a mindset shift

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Peripheral European issuers need a mindset shift

Borrowers have only themselves to blame for not getting ahead with their funding

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It has long been known that the European Central Bank would taper asset purchases this year, but it became even clearer in the first quarter that the ECB had misjudged the scale and pace of inflation and the speed with which it may need to raise rates.

Recognising this, banks with a market-based approach to funding wasted no time getting ahead with their covered bond issuance this year, certain in the knowledge that there would be a distinct advantage to those that moved early.

With the passage of time, spreads have widened and access to longer durations has become trickier, suggesting that the early bird strategy had paid off. This was especially the case for the financial sector in countries like France and Canada, where funding needs were large.

But issuers elsewhere also saw sense in bringing forward their funding plans, propelling first quarter covered bond volumes to €76bn, the highest rate of issuance this decade.

And yet, with only three Italian deals, one Spanish transaction and nothing at all from Portugal, Ireland and Greece, issuance from Europe's periphery has been notable in its absence.

Banks in these regions may have felt a lack of pressure to get on with funding for understandable reasons — high and sticky deposits twinned with subdued mortgage lending. But it is doubtful whether this dynamic will hold true in the coming months. Spiralling energy costs and food prices have turbo-charged inflation, which is bound to eat into retail deposits eventually.

Negative cost of TLTRO carry

Peripheral European issuers may also be waiting for the new terms of the ECB’s Targeted Long Term Refinancing Operation, which are expected to be unveiled in June.

The TLTRO probably won’t vanish altogether, but it’s almost certain that the special low borrowing rate of minus 100bp will shift into line with the deposit rate of minus 50bp.

The TLTRO has provided helpful funding for many issuers, but was primarily used as a means for improving profitability. By pledging covered bonds in return for funding at minus 1%, issuers were able to deposit this liquidity back with the ECB at minus 0.5% for a tidy risk free profit of 50bp.

Without this arbitrage, the TLTRO will make little sense, particularly if rates rise more steeply than expected. Factoring in three or four ECB rate increases of 25bp each by June 2023, when the largest TLTRO repayment is due, could result in borrowers incurring a penalty on their average TLTRO borrowing rate over the period. The positive cost of carry that they had earned potentially switches to a negative cost of carry or, in other words, a loss.

And although it seems likely that the ECB will unveil a backstop facility to contain spreads, this is only likely to be triggered as a contingency mechanism to be used under extraordinary circumstances, rather than a crutch to be relied on even when markets are functioning normally. In any case, no one yet knows how such a device would work and when it could be expected to be in place.

As a result, this Thursday’s ECB press conference is likely to be a decisive one for banks weighing up the pros and cons of continued TLTRO usage.

A tilt in the balance will free up covered bond collateral, providing issuers with the flexibility to reconsider their approach to covered bond market funding.

Regulatory funding will remain a priority. But for those that have failed to surface so far this year, the case for covered bond funding will only strengthen. And as those that have gone before can readily testify, the sooner it is done, the better.

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