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Covered bond traders positive on spreads as they await ECB

By Bill Thornhill
19 Jul 2021

The spread outlook for covered bonds is likely to remain positive over the summer period, said traders, even though yields are negative. The main risks to that prognosis are likely to emanate from the possible course of inflation.

Central bankers could be stuck “between a rock and a hard place” said one trader on Monday as he feared that they would be hamstrung if inflation continued to rise, even as the economy faltered.

A steep rise in the Covid-19 infection rate is thought to be likely to lead to renewed lockdowns in autumn, effectively scuppering hopes of a recovery in the second half of this year.

This should mean monetary policy remains accommodative, said the trader, but only if inflation proves to be as transitory as global central bankers believe it to be.

“The ECB has to keep its foot to the floor,” he said. “Recovery is now on the back burner, but if inflation is here to stay central banks will face a reality check. Last week they said it would be transitory, but there are only so many times you can say that before it’s not. It feels like we’re tenterhooks.”

A second trader agreed, suggesting this Thursday’s ECB meeting could contain some surprises. He thought the recent yield move lower had gone too far and suggested this could undermine demand for covered bonds with maturing longer than 10 years as swap yields are now negative.

German savings banks, which typically only invest in covered bonds that are positive yielding,may now have to look at longer dated issues.

However, many bank investors are unable to extend this long and such issuance would compete more directly for investors’ attention with bonds from the EU, which plans on issuing €35bn over the remainder of the year, aiming for an average duration of 15 years.

The seven to eight year area could prove a more durable sweet spot for covered bond issuers, particularly from outside the eurozone, where a double digit spread over mid-swaps could just about bring yields back into positive territory.

A third trader was equally upbeat on shorter dated bonds. Despite the fact that five year swap yield was at minus 0.33%, the spread pick-up of core covered bonds to EU paper in this tenor is many times higher than that available in the 10 year sector.

Rally overdone

He also said the recent rates rally was overdone and for that reason thought some accounts were likely to become more hesitant to buy covered bonds in the 10-15 year area.

Having shed 25bp since the end of June, 10 year Bund yields were trading 4bp below Friday’s close at minus 0.39% on Monday afternoon, levels last seen in mid-February.

Issuance is likely to remain limited as banks continue to seek funding from the ECB. This means net supply will become more negative over the course of this year. The expectation of weak supply came amid news that BNP Paribas had issued and retained a €3bn covered bond last week.

“As long as this reliance in central bank funding continues, supply will be limited and from a relative value perspective, covered bonds are not really expensive [in the five to 10 year]” he said.

He felt that even if the present aversion to risk become more entrenched, the market would still be fine. “The Street is clean with no massive longs and we won’t see any EU or covered bond supply until September,” he said.

Covered bonds in the four to seven year area have scope to outperform SSAs over the next few weeks as bank investors put on carry trades over the summer amid no primary supply and continuing central bank buying in the secondary market.

By Bill Thornhill
19 Jul 2021