Author: Michael Weigerding, Covered Bond Research Team, Commerzbank AG
Amid falling oil prices and economic slowdown in China, covered bonds have been one of the rare asset classes that have been fairly unaffected by the market turmoil at the start of the year. Supported by continued ECB buying and their low-risk structure due to dual recourse, the sector has seen spreads hold firm since late January.
But that’s not to say 2016 won’t be without certain challenges. Below we take a look at the key themes which we believe will characterise the international covered bond market over the rest of 2016.
ECB buying continues to support market
As part of its ongoing quantitative easing programme, the European Central Bank (ECB) should continue to be a heavy buyer of covered bonds in 2016 and on into 2017. By the end of 2016, we estimate the ECB may hold up to 20% of eligible covered bonds while its share in the eligible benchmark segment could rise to 30%.
However, the ECB’s buying patterns for covered bonds have seen an important strategic shift in the last year. Purchases have shifted from 80% in the secondary market to a more even split between primary and secondary markets. Given reduced capacity in secondary markets this increased focus on primary volumes should remain in place.
Investor universe impacted by lack of liquidity
Despite this trend, the lack of liquidity in secondary markets is likely to be an ongoing theme in 2016. Liquidity was already a topic before the ECB stepped in, but since the start of the central banks’ third covered bond purchase programme (CBPP3), we estimate trading volumes have dropped by a third. We do not see this trend coming to an end soon as we expect that the central bank will keep buying at the capacity of the secondary market over the course of 2016.
As in 2015, this could limit demand for covered bonds among real money investors, such as asset managers, who require a certain amount of liquidity for active portfolio management. As a result, new issue order books with 100+ of genuine investors have already become a rarity. Luckily, however, covered bonds have come to look significantly more attractive again in relative value terms, which has contributed to rekindling investors’ interest in the asset class.
Spreads vulnerable to greater volatility
As liquidity continues to be scarce we should expect to see more volatility in covered bond spreads though. As we saw in 2015, this is likely to be a particular issue towards quarter-ends when market makers are seeking to reduce their exposure. For example, excluding the year-end, last year the trading volume in peripheral covered bonds typically decreased by more than a fifth towards the last week of a quarter. This scarcity also affects segments not eligible for the CBPP3. Despite the covered bond sector’s relative stability in the face of macro-economic turmoil, such increases in spread volatility could again reduce its attractiveness for investors. Of course, ECB buying should provide substantial support, but as we have seen in the past, the central banks do not necessarily immediately step in when spreads are widening.
Extendable maturities becoming the norm
In terms of product trends, soft-bullet maturities, where redemption dates can be extended under certain circumstances, should continue to see their popularity grow this year.
Extendable maturities have become increasingly appealing to issuers seeking to manage their over-collateralisation requirements. As extendable maturities give the pool manager more time to sell assets after an issuer insolvency, soft-bullet structures might assure a higher recovery value and greater ratings stability. In terms of spread differential there is no significant difference between hard- and soft-bullet structures.
There are only a few frameworks left in Europe that do not make use of extendible maturities for covered bonds on a broader scale; in particular Spanish Single-Cédulas, Austrian covered bonds and German Pfandbriefe. However, 2016 could see Germany move its Pfandbrief framework towards a soft-bullet regime. Given the country’s dominance in the euro benchmark market, this would substantially accelerate the structure’s market penetration.
Strong property markets to increase supply
With the ECB continuing to buy around 30%-40% of all CBPP3-compliant new covered bonds, this remains a well-supported market for issuers. At the same time ongoing low interest rates should continue to underpin mortgage markets while keeping a lid on demand for private placements. As a result, we should see overall euro benchmark covered bond supply 2016 increase slightly compared to 2015. With more than €50bn already placed, the start of the year has indeed been promising in this regard.
Newcomers continue to contribute to a more diversified issuer universe. In Asia, notably in Singapore and Korea, banks show increased interest in the sector, as are debut issuers in various established markets.
Harmonisation – time to wait and see
Finally, the European Commission’s plans to harmonise European covered bond frameworks should continue to produce headlines this year. But with the actual legal implementation not due until 2017, they are unlikely to already affect spreads any time soon. In principle, for countries with a weaker regulatory framework harmonisation should be good news in terms of investor demand. In the end, however, the devil will be in the details.
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