The evolution of the post-ECB covered bond market

In July, for the first time in eight and a half years, the European Central Bank stepped out of the covered bond market. With its gradual reduction of buying in the primary market, from its initial order of 40% of an eligible deal, the ECB withdrew first from buying new euro covered bonds at the end of February to, by the summer, ceasing secondary market purchases too.

The withdrawal from both primary and secondary markets formed part of the ECB’s fight against inflation. This departure of the single biggest investor in the asset class has transformed the market.

“The ECB had a strong impact on the market — its withdrawal was a game changer as the market dynamics have completely changed,” says Tarek Petzold, head of debt syndicate and private placements at LBBW in Stuttgart.

Bodo Winkler-Viti, Berlin Hyp’s (BHH) head of funding and investor relations in Berlin, says: “For issuers, the most visible aspect of the post-ECB market is the central bank’s absence in primary orders.”

The ECB’s withdrawal as a buyer of covered bonds coincided with and amplified the effects of the approaching end of its Targeted Longer-Term Refinancing Operations (TLTRO). The expiry of this cheap central bank funding, which was extended to eurozone banks in 2019 and then sweetened further during the Covid-19 pandemic, meant banks had to refinance it elsehwere. Meanwhile, banks outside the eurozone have also started to repay similar programmes offered by their central banks.

The disappearance of this cheap cash has propelled covered bonds to the top of the menu as one of the most cost effective funding tools for all banks.

“Covered bonds, among others [products], seem to be gaining in importance again for the refinancing of banks,” DZ Bank said at the end of July. “The cheap TLTRO III loans still have to be repaid until 2024, so that bank funding via the central bank will become less and less important in the coming months.”

Therefore, it was no surprise that last year was such a busy one for covered bond issuance as the end of TLTRO approached.

Public covered bond issuance breached €200bn for the first time last year, ending at a record of around €204bn. Market participants predict this year could finish with a similar volume. LBBW tracked around €150bn of public deals issued in 2023 by August 23. It expects another €50bn-€55bn more by the year end.

This high volume – which some also expect in 2024 as well – together with the cycle of major central banks’ shrinking balance sheets and their aggressive tightening of monetary conditions has raised an uncomfortable question, however.

“How can this new volume of covered bonds best be absorbed?” asks Iason Ioannidis, FIG syndicate at ABN Amro in Amsterdam, echoing other European syndicate desks.

“So far private investors have taken [this huge volume] well because of the higher spreads,” he says. “However, there may arrive a point at which spreads alone might not be convincing for investors to keep on buying.”

Another syndicate manager at a different European bank says that “the question of how much supply we will be seeing may lead to a point when investors will simply say: ‘OK I had enough and I’m not interested anymore at any spread’. Should we reach such a point, investors will be spooked and we will get into a vicious circle that can only get worse.”

The seemingly unabating supply has had an impact on banks’ cost of funding. The iBoxx € Covered Bond Index ended the week of August 14 at 22bp — just 3bp higher than the start of the year. However, this was already 19bp above where the index opened trading at the start of 2022 — a whopping 630% rise over this 19 month period.

Petzold says: “While I’m not too worried about valuation at the moment, the high supply of this and next year is the big question mark hanging over the state of the market.”

The transition to higher spreads from 2022 to 2023 was not purely the result of the supply deluge. Spreads have been heavily influenced by central banks’ rapid interest rate increases.

Consequently, however, these higher spreads, as well as yields on newly issued covered bonds, have worked in favour of issuers and investors.

Wide Bund/swap spreads and the relative value resulting from the repricing of the asset class have benefitted new deals. Investors have become more eager to buy at these new valuations.

Moreover, for the foreseeable future, investors are expected to be heavily invested in fixed income because of the higher yields, according to analysts. “This doesn’t necessarily mean they will stay in covered bonds,” says Ioannidis. But the asset class is likely to remain attractive, because even “expensive tier one German covered bonds are offering a pick-up versus SSAs”, he says.

Investors have embraced this year’s spread widening of covered bonds, as peak inflation and the end of the rate rising cycle are seemingly approaching.

In 2023, “everybody had expected the ECB’s exit from reinvesting the proceeds of covered bond maturities, but so far there hasn’t been a real, meaningful widening because every single smaller widening brought new and more investors to the covered bond asset class,” says Ioannidis.

Indeed, these higher spreads have resulted in a juicy pick-up over many other high-grade assets. “The relative value of covereds versus SSAs is huge,” says one syndicate manager at a French bank.

Assuming that a core French five year covered bond might have been sold around 22bp-25bp over-mid swaps in mid-August, he says this would have resulted in yields around 60bp higher than five year French government bonds.

“They are not the same risk — a sovereign and a covered bond — or the same risk weighting, but we are still talking here of a triple-A risk with a huge 60bp pick-up,” says the banker. “After all, relative value and risk sentiment matter.”

Due to an already wide gap between SSA and covered bond spreads, the syndicator at the French bank does not think that “covereds will widen by anything as much as 20bp-25bp by the year end”.

This kind of a widening will create an even bigger gap that “will make them too cheap versus SSAs and senior preferred debt,” says the banker.

However, given that there is “at least €200bn of volume expected for the full year,” BHH’s Winkler-Viti thinks “there is not too much of a potential for spread tightening ... especially for the more expensive products”.

Still, he also sees only a “limited” widening of a few basis points by the year end, and he anticipates “no need for excess widening”.

“Even with the 0bp-5bp spread widening that ABN Amro expects by the year end, based on our investor survey across all covered bond jurisdictions, we expect this relative value pick-up to remain an attractive proposition for investors,” adds Ioannidis.

Investor interest sharply increased just before the summer when concessions “sky-rocketed to 7bp-10bp”, says Ioannidis.

“That saw second rank [covered bond] issuers like PBB (Deutsche Pfandbriefbank) and Aareal attract a lot of demand for their deals on the back of the higher premiums they paid,” he says.

On July 6, despite concerns about the commercial real estate sector to which PBB is heavily exposed, investors placed €1.1bn of orders for its €500m 3.625% October 2026 deal. The bank paid a premium of 8bp.

Demand was stronger just five days later, when another real estate lender Aareal Bank paid a 10bp concession to achieve its largest Pfandbrief order book, attracting €3bn demand for its €500m 3.875% May 2026 deal.

This strong interest then is noteworthy as there were hiccups in the market not long before that. For the first time in the covered bond market a deal was pulled after its final terms were set. In the second part of June Bausparkasse Schwäbisch Hall attempted to print a €500m no-grow 10 year mortgage Pfandbrief. The pricing implied what had until then been considered a reasonable concession of 5bp-6bp. However, finding lukewarm interest for its long dated deal, the issuer opted to pull the trade.

Investor sentiment has shifted since the ECB’s exit, making pricing, fair value discovery, and book building more challenging.

This is because investors have become “more selective in this post-ECB windows market,” says Marc Just, FIG and SSA origination at LBBW in Stuttgart. When the ECB was actively buying, premiums were “for sure” lower and now “that [absence] has made it, at times, more challenging for issuers to meet investors’ higher request for premiums,” he says.

LBBW’s Petzold says: “After the ECB’s withdrawal, investors have started to behave more tactically. They have become more hesitant to put their orders and, consequently, the order book development has been much slower.”

This phenomenon is due to the so-called fast money accounts that have largely stopped buying covered bonds as they have become unable to sell their paper to the ECB.

“For fast money, the free lunch is over,” says Just. “They knew this would come as the ECB’s withdrawal from the secondary market approached. Then after February you could say there were digital books: fast money was in on some trades and not in many others.”

Instead, the increased investor interest is coming from real money accounts, says Petzold. Moreover, “some asset managers and insurance companies that have been dormant during the negative and zero yield days are back now in the asset class,” he adds.

Real money buyers have created something of a compensation for fast money orders that have largely disappeared.

“But what’s clear is that definitely the momentum behind covered bond deals is completely different than what we saw last year,” says Petzold. “That’s why many issuers pre-announce their deals [a trading day before pricing] to get a sense of what investors are thinking.”

BHH, a respected name in the covered bond market, illustrates the changes since the ECB’s withdrawal.

Every year since 2019, the lender has reopened the market after the summer lull. In both 2022 and 2023 it issued on August 16.

“For both 2022 and 2023 deals, the market conditions were good for us to issue,” says Winkler-Viti. “But then and now it was a different market. Last year we had a ridiculous €6bn book for a three year bond that was €1bn in size. The book included investors that are not known as covered bond investors.”

This year’s €500m 3.375% five year social bond attracted a formidable book of €1.6bn while offering 4bp of premium. But thanks to fast money demand the €1bn 1.25% three year green deal in 2022 had an unmatched subscription ratio even when it offered a concession of just 1bp.

“What I want to see in my order book is true interest from investors – a more honest interest in my bonds from investors that will stay for the long term and not people waiting for a few basis points of performance and then sell a week later,” says Winkler-Viti, referring to fast money investors’ tactic of reselling primary paper to the ECB.

“An issuer would prefer to place its bond with real money, buy-and-hold investors,” says Just. “However, fast money investors help a deal as they tend to come at the beginning of the bookbuilding and they can contribute towards the momentum building of a deal.”

However, a bigger book naturally provides bigger pricing power. Because of the larger books, “last year’s tightening in price guidance of 5bp, 6bp or 7bp happened quite regularly,” says Winkler-Viti, “whereas now a 5bp tightening is rather the exception”.

The smaller books are a function of the ECB’s withdrawal and form part of a new differentiation process between issuers and jurisdictions.

“We have now reached a different equilibrium after one big buyer is gone,” says Petzold. “Yet, now it’s easier to understand which pricings and new issue premiums work for deals.”

BHH’s funding head agrees: “You could say that we are now back to a normal market — a market where prices are determined by what’s on offer, its quality and investors’ demand.”