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Issuers in charge as covered supply to stay squeezed

21 Dec 2012

Covered bond investors suffered in 2012, a year that was marked by meagre issuance and secondary illiquidity. Those looking for respite in 2013 are likely to be disappointed. Falling funding needs and a preference for senior unsecured supply are among the factors keeping analysts’ expectations low. But as Steve Gilmore writes, there are still glimmers of hope for a better year.

Covered bond issuance crumbled in 2012. Over-optimistic analysts who had earlier predicted €190bn for the year were forced to revise their predictions by June. By then it had become clear that two colossal Long Term Refinancing Operations from the European Central Bank would rob the market of billions in public issuance. Even the most cautious estimates failed to capture the decline.

By early December, euro benchmark issuance for 2012 had struggled over the €100bn line, with supply contracting by around 45% compared with 2011. Even taking into account increases in dollar, sterling and Australian dollar supply, overall issuance was down almost 30%.

The good news is that most analysts expect an increase in 2013; the bad news is that it will not be by much, and nowhere near enough to ease the pent-up demand of a hungry investor base. Crédit Agricole and Barclays analysts expect around €105bn in euro benchmark issuance in 2013, with others predicting only a "slight increase".

Firstly, widespread deleveraging has left issuers with lower funding needs. Nowhere is this more evident than in France, which is still expected to be the largest jurisdiction by issuance in 2013. Caisse de Refinancement l’Habitat, which funds on behalf of the French banking system, sold almost €11.5bn in euro covered bonds in 2011 but only €4.5bn in 2012, from two benchmarks and a tap. The borrower was absent for the entire second half of 2012, surprising even French syndicate bankers and illustrating the declining need for funding.

Issuance in 2013 is also likely to be marred by a trend towards senior unsecured supply at the expense of secured funding. "Covered bonds will remain a key tool for French issuers, but like everywhere else in Europe, senior unsecured issuance will be the cornerstone of bank funding in 2013," says Vincent Hoarau, head of financial institutions, covered bond and ABS syndicate, at Crédit Agricole CIB in London.

Some covered bond analysts believe that covered bond issuance from France will still manage to hit the €30bn mark in 2012, but with €28.5bn in redemptions Hoarau expects net French covered bond benchmark supply to be negative for the first time ever.

Compressed and encumbered

One reason for the switch to senior is spread compression between the two asset classes. In the current environment, where the gap between senior and covered spreads is very tight, it makes even more sense for some issuers to tap the senior market, says Fritz Engelhard, head of covered bond research at Barclays in Frankfurt. When the absolute spread difference is 40bp-60bp, you can keep the collateral for when you really need it, he says.

Increasing concern about asset encumbrance adds yet another incentive to be sparing with secured funding. Most jurisdictions new to covered bonds are attaching encumbrance limits to their legislation, and in established markets like Norway and Sweden, regulators are worried about the effect of covered bonds on the banking system and the mortgage market.

Barclays analysts say that restrictions on collateral in these two jurisdictions, through regulation or availability, combined with cheap senior unsecured spreads, will lower Nordic supply in 2013.

The sentiment is spreading to other countries. In France the regulator is concerned about the growth of covered bond funding, its effect on the housing market and the imbalance it can create in banks’ funding mix, says Hoarau.

The ECB’s stellar success in providing short-term liquidity to the continent’s banks is another drag on covered bond issuance. For southern European issuers with billions in covered bonds sitting at the ECB, issuing publicly could exacerbate already high levels of encumbrance. European banks — mostly in France, Spain and Italy — issued over €300bn in retained covered bonds between October 2011 and October 2012, according to Barclays analysts.

Lower haircuts and less onerous reporting requirements make covered bonds far more attractive than RMBS as a repo tool. And in many countries banks are still replacing RMBS with covered bonds as collateral for repo funding, says Engelhard. This big rise in retain issuance will have a lasting effect on primary supply, say the Barclays analysts.

Positive on the periphery

But the outlook is not all doom and gloom. From January 2013 banks can and will start to amortise their LTRO funding (see page 44).

This will be easy for the strong core names, as most have outstanding bonds as long as five years that yield less than the LTRO’s 0.75%. In late October, Münchener Hypothekenbank sold a two year Pfandbrief 20bp inside mid-swaps with a coupon of only 0.125%. For these borrowers the primary market has simply become more attractive than the ECB.

For peripheral issuers, rating pressure and bail-in discussions will keep senior spreads high. But issuers like Intesa San Paolo and Banco Bilbao Vizcaya Argentaria have demonstrated that with secured collateral they can price well through their respective sovereigns.

Periods of market stability are becoming longer and peripheral spread levels lower. In addition, older mortgages are slowly being repaid and new ones issued at rates that better reflect the new economic environment.

"As the differential between what issuers’ assets yield and the levels at which they fund narrows, slowly but surely the economics of primary transactions start to look better and better," says Richard Kemmish, director of DCM at Credit Suisse in London.

Huge order books on deals from the same issuers leave no doubts as to the level of demand for high coupon covered bonds, and although real money accounts are still holding off, that could be about to change.

"Those accounts are still trying to convince their risk departments to re-establish lines," says Leef Dierks, head of covered bond research at Morgan Stanley in London. "But the longer we see relative stability, the higher the chance these lines will be restored."

The national champions have set themselves apart from their peers, but investor appetite extends further down the credit spectrum.

"We’ve seen a lot of convergence trades set up betting on weaker names closing the spread gap with better rated issuers in the same jurisdiction," says Dierks. "This implies investors are becoming more positive on riskier but higher yielding credits."

Crucially, if peripheral issuers do find themselves in a position to take advantage of renewed real money interest, they have a way to do so without tying up more assets. Taking covered bonds sitting at the ECB and using the collateral to issue new transactions in the primary market is an encumbrance-neutral way of demonstrating market access and amortising down LTRO debt, says Kemmish.

Redeeming feature

Several other factors are set to support issuance. A large amount of last year’s shortfall was due to borrowers bringing transactions in other currencies, like dollars, because the basis swap was firmly against euro issuance, says Kemmish.

Swedish borrowers, for instance, launched eight euro jumbo deals in 2011 but only one in 2012, focusing instead on other currencies like dollars and Australian dollars.

The basis swap has now normalised, says Kemmish, and this should make euro issuance far more appealing. This shift occurs against a huge increase in euro benchmark redemptions from €112bn in 2012 to €177bn this year, according to DZ Bank analysts (see graph).

New faces and old friends are set to expand the covered bond universe in 2013. In France, Dexia Municipal Agency is expected to return after the EU Commission approves its new business model, and La Banque Postale is setting up a covered bond programme.

In November, Bank of Ireland restarted Irish issuance after a three year enforced absence, closely followed by Allied Irish Bank. Belgium’s KBC and Belfius Bank launched their debut deals in 2012 and analysts expect €5bn-€6bn from the new jurisdiction in 2013.

Further afield, Şekerbank is looking to leverage Turkey’s new investment grade rating and bring its first public covered bond. Smaller regional issuers in Canada, Australia and New Zealand are better placed than ever to look at the primary market. Second tier in these countries does not meant lower credit quality, and investors can no longer afford to dismiss borrowers because of infrequent issuance.

But even allowing for cautious optimism, supply will not be enough to sate investor appetite, say bankers. And this will change primary market dynamics.

"Private placements will become more important, and in the public market the pricing power will be in issuers’ hands," says Hoarau. "New issue premiums have already disappeared and issuers will opt for more frequent smaller deals rather than jumbo issuance."

In addition to size and spread, the lack of supply could also alter the tenor of issuers’ transactions. "The first half of 2013 will likely be characterised by the increasing scarcity of liquid, benchmark sized, euro denominated rates products," says Dierks. As a result, borrowers would be well advised to postpone issuance until later in the year and try to secure longer dated funding, he says.

Investors have good reason to look forward to an increase in issuance, particularly from new jurisdictions and a resurgent periphery. But there are enough factors suppressing supply that when it does come, it will be firmly on borrowers’ terms.
21 Dec 2012