Higher rates for longer favours covered bonds
Covered bonds offer wholesale funding salvation in the new monetary policy era
Covered bonds have been around since 1769 but their heyday was in 2011, when gross issuance volumes across all currencies peaked at almost €200bn.
During that period, sandwiched between the Global Financial Crisis and the European Sovereign Debt Crisis, volumes were boosted by strong growth in new jurisdictions and a vibrant European market that was, for the briefest of moments, spared the distorting effects of central bank intervention.
The European Central Bank’s first covered bond purchase programme had ceased in June 2010 and the encore would not begin until November 2011. At that time, 10 year Bund yields, at 2.35%, were more than double Tuesday’s level of 0.93%.
More importantly, annual inflation peaked in December 2011 at 2.7%, which, though not particularly high in the vast scheme of things, was nevertheless the highest in a decade.
It couldn't last. Inflation went on to fall back below zero, taking 10 year Bund yields with it into negative territory. Inflation then remained subdued for years before suddenly exploding to an annualised rate of 7.5% in March.
According to the European Commission's latest forecast, that is supposed to be the peak. But the EC and the ECB have been so consistently wrong footed that market observers might be wise to do their own sums.
Among those offering a second opinion are the strategists at ING research, who in March outlined their thesis that the ‘lower rates for longer’ mantra has now been replaced by 'higher rates for longer'. In their report, the ING strategists did not rule out the prospect of headline Eurozone inflation hitting double digits this year.
Gas and oil price shocks and wage growth are unlikely to be tamed until well into 2023, while the war in Ukraine, if it goes on for much longer, as it might, adds to the danger of inflation becoming more entrenched than anyone currently expects.
Higher rates for longer would lead to spiralling debt servicing costs and would cause a severe economic slowdown — bad news for almost all financial markets, possibly barring covered bonds.
Covered bonds are renowned for providing banks with access to competitive funding in difficult times, but have been forced into the shadows since 2011 by massive quantitative easing, which has gone from experimental stimulus tool to near orthodoxy for a generation of bankers and policy makers.
That era has now come to an end.
With the dawning of the new financial era, the crisis era funding tool of choice — covered bonds — will come back into the limelight.
As Luca Bertalot, head of the European Covered Bond Council, recently said, covered bonds are now back to their role “as a fundamental strategic asset class”.