"The covered bond market has taught us a lesson: once you create a non-homogeneous market, you cant go back."
There has been much debate about whether covered bonds are a credit or a rates product in the 18 or so months since inter-dealer market-making in jumbos began to crumble in August 2007, but this comment by Lucette Yvernault, global credit fund manager at Schroders Investment Managers, at the Euromoney Bond Investors Congress in London in late February captures the reality of the situation the market finds itself in more neatly than most.
Firstly, it undeniably sums up what investors have come to think about the product since the crisis struck: that there is a credit element to covered bonds.
Secondly, it tells issuers that harking back to the good old days when all the different structures and jurisdictions traded in a tight range is no more than wishful thinking. It is never going to happen.
However, while this might seem blunt, investors have nevertheless been telling issuers that it does not have to mean the end for covered bonds. Far from it.
Many investors have warm words for covered bonds.
"Its a market that I like a lot," says Daniel Loughney, a portfolio manager at AllianceBernstein in London, "and from my involvement with European investors, they love the market.
"Theyve got money to put to work and they want to be involved in it. So I can definitely see it coming back.
One investor at the Euromoney conference even asked panellists if covered bonds might even trade inside sovereign paper given than they would benefit from being collateralised in the event of a sovereign default. Loughney, for one, said that for particular sovereigns, and for certain covered bonds, that might be true.
"Covered bonds have characteristics that are very, very attractive," he says.
Given that investors appear completely comfortable with the credit element of covered bonds that has been amplified by the crisis, are market participants obsessed with the rates/credit debate therefore barking up the wrong tree?
"I think the real issue with the European covered bond market is liquidity," says Loughney. "The banks have stepped aside."
He says that the lack of balance sheet available for covered bond trading has resulted in a change in the dynamics of the market. "Investors expect to deal in covered bonds with maybe 1bp-2bp bid/offers," says Loughney, "but were looking at 40bp-50bp now, so theres no market."
Other investors say that it is to compensate for the lack of liquidity that they are asking for higher spreads.
One fund manager in Frankfurt, for example, says that he needed more of a buffer because covered bonds are harder to turn around, making them more of a buy-and-hold investment.
Another agrees, saying that the way he regards the product has changed.
"We have not decreased our holdings of covered bonds," he says, "but we treat them differently. Previously we were very active, doing relative value trades to gain 2bp or 3bp. Today, they are more of a structural trade as to do a relative value trade you would need a really big pick-up to compensate for the greater cost of doing it."
This is where the market has come unstuck: in not living up to expectations. And, as with the lack of homogeneity of the market, the lack of liquidity is going to be a tough genie to put back into the bottle.
One eastern European central bank investor says that covered bonds were marketed to the investor base as a liquid product, and that it would therefore be hard to strip covered bonds of market-making, as that would change the nature of the asset class and it would need to be reassessed.
And one London portfolio manager says that the lack of market-making and the way in which that had made covered bonds more of a buy-and-hold product had effectively lengthened the duration of the investments in the asset class, which had to translate into a higher spread.
The extent of the liquidity problems facing investors are highlighted by one Munich-based portfolio manager. He says that if he wants to trade a ticket of Eu5m-Eu10m and calls eight to 10 banks he can find hardly any bank quoting a decent price. Three or four might not be trading the bond at all, he said, and the rest give him a price thats "just not worth mentioning".
If you can sell a bond, he adds, it is because the trader has found an investor to sell to. He says that when traders are doing this, "thats more or less risk-free money", with banks taking 20bp for buying from one investor and selling to another.
The London portfolio manager says that it would be worth exploring the idea of setting up an exchange where this could be done independently of market-makers. He says that investment banks would of course not like this as they could not make fees and that the trading community would be more or less redundant.
The central bank investor sees this as a natural development.
"Before investors were lonely fighters in the market," he says. "We hardly spoke to each other. Nowadays when I have selling or buying interest it is more natural for me to ask the investors that I know if they want to take the opposite position."
He says that while any subsequent trade might be conducted through an investment bank, the fees for this service would not be 20bp.
"The crisis is set to continue for some time now," he adds, "so this will eventually mean... we will set up the links and then we dont even have to show the flow to the market at all.
"Its not a solution, because the trading community had a meaning in this market, but for the time being its a way for us to save a lot of money."
Smaller not better
In the meantime, investors are unimpressed at suggestions that smaller issue sizes might be the way forward for the covered bond market to regain momentum.
The London-based portfolio manager says that smaller issues would probably be "a bad thing" as they would not help liquidity.
The idea of smaller issues is not in itself problematic, according to the Munich-based portfolio manager, but he says that deals of less than Eu1bn would not be included in benchmark indices, and that their criteria would have to be changed if issues of Eu500m or Eu750m were to become more common.
However, Louis Hagen, executive director of the Association of German Pfandbrief Banks (vdp), has suggested that if enough market participants accepted the idea of smaller deals then it should not be difficult to get index standards changed.
The London-based portfolio manager nevertheless cautions that if sizes go back to Eu500m (roughly the original jumbo size of DM1bn), a new policy for taps will have to be thought out so that they are done in an investor-friendly way. He says that previously taps had been "something of a dirty word".
And the Frankfurt-based fund manager says that he would not be comfortable buying into a Eu500m deal of which Eu200m might be held by one central bank.
He says that while it made sense to look anew at the markets fundamentals, the idea of reducing issue sizes was perhaps taking this too far and was a move in the wrong direction. In his opinion, the debate is getting causes and effects mixed up.
He suggests that investors are only placing smaller orders because of the difficulty they are having in trading in and out of bonds, which is much more expensive than in the past. If liquidity is improved, he argues, ticket sizes could grow.
Another fund manager backs up this argument.
"If you look at the two French issues and several taps that came out at the beginning of the year," he says, "they showed the market in general and traders in particular what the clearing price for French covered bonds was. That meant that traders had more confidence taking bonds on to their books as they knew what the correct level was, and the French sector became more liquid.
"We then saw that to an extent with Pfandbriefe after the two German jumbos came out. If issuers go ahead and bring new deals into the primary market, the price discovery process that accompanies that may be the best way to reduce bid/offer spreads and improve liquidity."
However, investors do have some sympathy for the tough job that issuers and market-makers have in trying to reintroduce liqudity into the covered bond market. The Frankfurt fund manager, for example, says that while nothing had been done yet to address the problems that had come with the breakdown in market-making, liquidity is a general problem and not one confined to just covered bonds.
Loughney at AllianceBernstein agrees. "It goes back to the really big picture which we have, where markets are being heavily affected by liquidity," he says.
Covered bonds are being affected by it, he says, but so is anything below senior debt (which he considers one of the most liquid products) and any sovereign issuer outside the top few in Europe. A solution to covered bonds liquidity problems, he suggests, might have to wait until the general malaise is eased.