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Thursday, 14 December 2017

Back from the brink

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The covered bond market had been a serious casualty of increased investor risk aversion in the wake of the banking crisis until a new buyer of assets was announced in early May: the European Central Bank. At a stroke it reversed the widening of covered bond spreads that had characterised most of the previous two years, reinvigorating the new issue market. Mike Winfield Reports.

The financial crisis that began in the summer of 2007 did not prevent the Triple A bond market from functioning, though it did transform its terms of reference. The covered bond market, on the other hand, suffered more dramatic consequences, seeing supply reduced to a trickle for most of this year. The intervention by the ECB, with its announcement of up to €60bn of covered bond purchases in the 12 month period starting in July this year at its May policy meeting, provided new support for the market. At a stroke, the supply tap was turned back on.

Although shrouded by a lack of clarity over details, the news led to a significant spread tightening, resulting in €16.25bn of jumbo deals being priced during May. After including taps, this "means that the average weekly issuance volume had risen from about €500m in the first 17 weeks of the year to almost €5bn in the four weeks after the ECB announcement," said Frank Will, strategist at RBS. If nothing else, investors at least had a better idea of where fair value lay in the market.

The initial ECB statement made no reference to the price at which it intends to buy assets, nor a required minimum rating, making the full impact on spreads difficult to assess. Even after the first stage of clarification a month later, which specified "the covered bonds had to be eligible for use as collateral in the ECB's credit operations", there remained unanswered questions. On the morning of the May announcement, covered bond traders had reported that buying in the sector was at the busiest level they had seen in months – particularly in core covered bond markets of France, Germany and Scandinavia. In the aftermath of the announcement some covered bonds, such as the Spanish multi-cedulas, were quoted around 50bp tighter. Traders in general said they had marked their books about 20bp tighter. But with very few prices and fewer covered bonds available to trade following a prolonged dearth of issuance, bid/offer spreads initially widened significantly, ahead of the June ECB meeting at which further details were announced.

In June the ECB said its "direct" purchases would be made from both the primary and secondary markets. It would target three to 10-year issues that met certain credit rating and size criteria (minimum AA and €500m). Although there remained a lack of clarity over how the purchase operations would be conducted, it transpired that the assets to be acquired were those covered bonds currently eligible to be posted as ECB collateral. Prior to the clarification, Deutsche Bank had already said that "some Germany Pfandbriefe had traded extremely tight again [following the original ECB announcement], with short dated issues at around mid-swaps plus 20 bp. On the other hand, some UK covered bonds were still bid at around swaps plus 350 bp …confirming that European covered bonds are very heterogeneous and some sectors lack secondary market liquidity."

The notion of covered bond purchases had been mooted for some months by the shadow ECB and, no doubt, the ECB itself, as a means of boosting the Eurozone economy. Jean-Claude Trichet, the ECB president, denied that the decision in principle to purchase covered bonds issued in the euro area amounted to quantitative easing. Instead, he stressed the idea was to revive a market that had been hit very hard by the financial crisis.

"Covered bonds were considered by the governing council as one of the segments of securities . . . that have been particularly affected in terms of impact of the financial turbulence," said Trichet. It was only a matter of days before the dearth of supply was addressed, as covered bond issuers lined up to ride the new wave of post-ECB optimism.

Immediate response

The creation of a valuation floor stabilised (and reversed) the slide in covered bond spreads which had seen German-based issues widen by 92bp year- on-year, according to Unicredit, and by 126bp over the same period for French issuers. "The widening tendencies that never had a fundamental backing but were solely driven by market technicals…will also lose this technical basis," the Italian bank said. The ECB wants to support the covered bond market: it is a vital funding tool in many European countries, including Germany, Spain and France, to finance the real estate market and, to a larger extent, the broader economy. "The purpose of this support is obviously to allow a smooth and sustainable reopening of the primary market which has been shut to most of the issuers during the past year," said a strategist at SG CIB at the time.

It was logical to assume the ECB would direct its action at eurozone issuers, but not covered bonds issued by institutions in the UK, Denmark, Sweden, Canada or the US. Following the statement of intent, the first transaction after the ECB meeting was for Banco Santander, which announced a €1.5bn five-year benchmark at mid-swaps plus 125bp area. It was the first jumbo Spanish Cedulas since June 2008 and the books for the deal reached €3bn within hours of opening, with zero price sensitivity reported. Pricing was therefore set at mid-swaps plus 120bp. Broad international interest at 75% of the final allocation complemented good domestic support, according to the leads, with Germany, Austria, the UK and Irish investors playing a significant roles.

On the day Santander was priced, Compagnie Financement Foncier followed with a 12-year deal at mid-swaps plus 123bp, taking advantage of the opportunity to extend its liability profile. The leads observed an increase in reverse enquiries from French and German investors for such longer dated paper, despite the terms probably being up to 17bp tighter than it would have seen the previous week. Spanish borrowers saw a more significant improvement, with some analysts suggesting as much as 50bp of spread tightening.

In the following weeks a succession of deals appeared, as issuers sought to take advantage of the re-opening of the market and the improved terms of issuance relative to senior unsecured debt. By the end of May, when Banesto sold a four-year Cedulas Hipotecarias at the same spread as Santander, its parent company, there were still no immediate signs of indigestion from the glut of new supply.

For issuers, the pricing differential between covered bonds and Double A rated, five-year senior unsecured debt might typically have been around 15bp before the summer of 2007. Santander's covered issue at mid-swaps plus 120bp compared with terms at plus 150bp for its two-year unguaranteed senior deal in early April 2009. This suggested a minimum 30bp, and more likely 40bp cost saving for the bank by issuing covered bonds. This helps to explain why the market responded so quickly in anticipation of the details of the ECB asset purchase programme.

Quantitative easing

There was much discussion at the time of the ECB's covered bond announcement if it was following the lead of the US Federal Reserve and the Bank of England down the path of quantitative easing. In fact, the ECB's actions are more clearly aimed at repairing the covered bond market – essential, given the important role it plays in financing the European economy – via the restoration of the new issue market and the improvement of the liquidity of the secondary market. The effect of its actions will, however, be comparable to those of the other central banks in terms of the target asset class – albeit without the same policy implications.

The size of the covered bond market is estimated to be around €2.3trn. In that context, the size of the ECB's planned intervention was relatively modest, although considering that only €96bn of new covered bonds were issued in 2008, the figure looks rather more significant. According to RBS strategist Frank Will, "excluding non-euro bonds and public sector covered bonds (on the assumption that the ECB would focus primarily on mortgage backed bonds given the high real economy impact) it would be more than 10% of total issuance."

The size of the ECB's intervention is consistent with that of the other central banks, according to Bernd Volk, head of European covered bond and agency research at Deutsche Bank. "While €60bn is negligible relative to the [asset purchases] of the US and UK, representing only around 5% of the Eurozone's monetary base and about 0.6% of Eurozone GDP this compares to the Federal Reserve’s and the Bank of England’s asset purchases which correspond to 10% of GDP and more than 100% of the monetary base," he said.

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