Covered bonds set to thrive in tricky 2023
After years or low issuance volumes, covered bonds had a stellar 2022. But although the year’s performance has left the market in an optimistic mood overall, the war in Ukraine, inflation, recession and falling house prices mean few participants are taking 2023 for granted, as our covered bond market survey shows. By Bill Thornhill.
At more than €200bn, 2022 is a record year for euro covered bond issuance, far surpassing the previous record set in 2011, when euro benchmark volumes hit €177bn. Issuance has been driven by a broad range of compelling forces, some of which will remain in place in 2023.
Unlike the senior unsecured market, the covered bond market has been open throughout 2022, although long dated maturities were sometimes out of reach. At the same time, yields rose by about 250bp, with the move from negative territory drawing back buyers that had been frozen out for years.
A scarcity of high quality collateral, which caused Bunds to perform relative to swaps, improved the pick-up and value of covered bonds against most other asset classes in the rates universe. And, crucially, bank funding requirements were bulked up by the overarching need to refinance central bank liquidity.
At the same time, mortgage lending maintained a brisk pace as deposit growth began to falter in some countries. These factors were compounded by a sense of urgency driven by a fear that spreads would widen, leading many issuers to accelerate their funding programmes.
European banks, in particular, were obliged to start repaying €2.2tr borrowed under the European Central Bank’s Targeted Long Term Refinancing Operation. But Canadian, Australian, Swedish and latterly, UK banks, also faced similar pressure to repay pandemic-era central bank funding.
The vast proportion of the ECB’s TLTRO was used by banks to earn a risk-free profit, but after the ECB tightened terms in October, this incentive was removed. The motivation to repay early was exacerbated by June 2023’s €1.2tr TLTRO repayment.
As this sum will not be eligible for inclusion in banks’ Net Stable Funding Ratio from December, they have even less reason to hold on to it. Banks returned €296bn in November and, assuming the €1.2tr is repaid, the repayment may triple to around €900bn in December.
However, it’s also likely that a small proportion of the total €2.2tr TLTRO borrowed was deployed for funding and this will need refinancing in the capital markets. As the next cheapest source of funding to the TLTRO is covered bonds, it will be the obvious refinancing tool for the majority of banks.
To avoid a refinancing cliff edge banks earnestly began refinancing the TLTRO in 2022, giving rise to the year’s record issuance. But this process will drive volumes in 2023 and 2024 as well.
For these reasons Barclays’ head of FIG DCM for the EMEA region, Mark Geller, feels bank funding needs were likely to grow next year. Even if asset growth is modest, “it feels like the propensity is to see larger funding needs for many issuers in 2023 versus 2022,” he says.
A poll of 40 market professionals undertaken by GlobalCapital in November showed that 75% expected 2023 issuance to be the same or more than 2022. Of that, 30% called for an increase of more than €20bn over 2022.
Refinancing central bank liquidity facilities will play a central funding role, particularly when it comes to UK banks which must collectively refinance £192bn of outstanding debt borrowed under the Bank of England’s Term Funding Scheme for SMEs.
But there is also a “perennial debate” about deposit growth, says Geller, who believes deposits “may come under pressure from more attractive alternative investments” such as higher government bond yields. Falling deposits will increase funding needs.
However, the head of FIG DCM origination at DZ Bank, Matthias Ebert, is more circumspect. A lot of 2022’s supply was geared towards the repayment of TLTROs, but he says the proportion used for funding compared to carry was not clear and varied for each bank.
As the composition of bank balance sheets becomes more risk-weight heavy in 2023, he assumes risk weighted assets will rise, meaning banks will rely more heavily on regulatory funding to meet their Minimum Requirement for own funds and Eligible Liabilities (MREL) ratio. Since MREL issuance also provides funding, it should lower the need to issue covered bonds.
Nordea Investment Management’s portfolio manager, Henrik Stille, also thinks covered bond supply “probably peaked” in 2022. As 2022 comes to an end, demand for housing has begun to fall below the lows of the financial crisis, he says. Since mortgage origination will decline again in 2023 “there shouldn’t be so much supply pressure”.
Euro issuance is typically driven by German and French banks, but in 2022 Canadian borrowers came to the fore with almost €30bn of supply. “I can’t remember the last time Canadian banks issued as much as this year,” says Isaac Alonso, head of DCM financial institutions at UniCredit in Munich. “If issuance from this region is the same in 2023, I would be in the camp of overall supply being somewhat higher than this year.”
Canada is expected to remain a large issuance region in 2023 but much of 2022’s Canadian supply was pre-funding and, if the euro basis swaps widens versus dollars and sterling, euro volumes would decline, say researchers at Barclays.
On the other hand, regions that have hitherto been absent could return. “Southern Europe is likely to become a more active issuance region in 2023,” says UniCredit’s syndicate manager, Alberto Villa. At least three Italian covered bonds “are being hampered by a lack of executability,” as the Covered Bond Directive has not yet been implemented in Italy. Villa assumes this will happen by December at the earliest.
But strong issuance in southern Europe is likely to be counterbalanced by less activity in other countries, such as Austria, where a lot of pre-funding was undertaken in 2022.
Yield curve is crucial
Scope for issuance is also likely to be determined by the shape of the yield curve. Traditionally, covered bonds have been used for long-term funding, but in 2022 that theory was turned on its head as the swaps curve flattened and then inverted, effectively disincentivising investors from buying long dated debt thereby preventing banks from issuing longer than five years in the final quarter of 2022.
In late November, two year euro swaps were yielding 2.88% and the 10 year returned 2.75%, not much different from the 15 year at 2.76%. For many, including UniCredit’s Alonso, an inverted curve is “always a sign of recession,” but whether it remains that way throughout 2023 is doubtful.
Many hope that growth will return to Europe in the second half of 2023, at which point the curve should resume a positive slope. “Maybe we see a couple of quarters of negative growth,” says Thomas Cohrs, head of financial institutions and capital markets at Helaba. A modest recession should be viewed as more of a correction than a real recession, he says, implying that large scale layoffs leading to a sustained rise in unemployment is not likely.
Should recovery take place, the swaps curve inversion may only remain in place until the second quarter of 2023 implying demand will initially be focussed on the short end, says Stille. But in the second half of 2023 the curve may normalise, at which point demand should begin to “push out along the curve,” he says.
If that were to happen, long maturities would be back on the table catalysing an uptick in supply as banks regain access to this sought-after part of the curve. Ebert is hopeful the ECB will get inflation under control and foresees a slightly positive swaps curve in the second half of 2023, in keeping with GlobalCapital’s survey, where more than half expected the curve to finish the year slightly positive.
But probably only just so. At 5%-7.5% by December 2023, 59% of survey respondents thought inflation would remain quite sticky. This implies rates would also need to stay quite high, giving rise to the impression that growth, though positive, would be negligible according to the same 59%.
But, if the crisis in Ukraine escalates energy prices may rise again and “the ECB will have to fight inflation with higher rates,” Ebert warns. In such circumstances the nascent European recovery would be scuppered, rendering the swaps curve flat or inverted, effectively shuttering access at the long end.
Spreads to shape supply
Aside from the curve, the supply outlook will be determined by the extent to which spreads widen, especially versus other asset classes. Almost half the survey respondents thought French five year covered bonds would end 2023 5bp-10bp wider against mid-swaps with more than 20% saying they will finish over 20bp wider.
Covered bonds could also lose value relative to other rates products, with two-thirds of respondents expecting the 10 year Bund swap spread to range between 50bp and 75bp.
In the closing weeks of the year, October’s extremely wide Bund swap spread of around 100bp had passed, with Bunds yielding 2% and swaps returning 2.75% in the 10 year.
A large increase in the supply of government bond issuance, along with the freeing up of collateral through TLTRO redemptions, should cause euro government bonds to underperform, says UniCredit’s syndicate manager for financial institutions, Florian Rathgeber. This implies scope for the Bund swap spread to tighten towards its long-term range of around 50bp, but this may not necessarily dampen demand.
“I wouldn’t say we’ve seen significantly more covered bond demand at this year’s wider [Bund swap] levels because there are other important metrics that investors look at,” says Rathgeber, with reference to the size of new issue concessions, the spread to other rates products, the pick-up over the Euro Short Term Rate and outright yields.
Ebert concurs that early repayment of the TLTRO should free up collateral [government bonds], causing the Bund swap spread to narrow. Furthermore, a potential de-escalation of hostilities in Ukraine would lower the Bund’s safe haven premium, he says.
Half of the survey’s respondents expected a truce to be agreed in Ukraine, leading to a cessation of the conflict in 2023. However, Stille doubts “Russia will back down or that Ukraine will accept a split,” putting him among the 35% who expect the struggle to continue well into 2025 or 2026.
In such circumstances, Bunds would continue to be viewed as a safe haven, even if SSA issuance were to increase substantially, says Cohrs, who points to the fact that Germany is a rich nation with a solid economy and limited debt. A prolonged conflict implies Bund swaps will stay wide suggesting covered bonds will continue to offer excellent value.
And much like Bunds, covered bonds tend to flourish in difficult conditions, says Cohrs. “It’s becoming almost normal to see an abundance of potential black swan events, but in any case, covered bonds seem to thrive under most scenarios.” GC