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Wednesday, 22 November 2017

Covered Bonds Roundtable 2008: Part One

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  • Sayuri Aoyama & Carlos Stillianopoulos

IFR: What is the current situation with liquidity and the secondary market?

Nicolas Poli (Merrill Lynch): At the moment covered bonds are like all the other markets, in that the underlying markets are undoubtedly facing a problem of liquidity. This is mainly due to the fact that everyone needs to raise cash at the moment, and hence we are seeing sellers of covered bonds. This in turn is why we have seen a massive widening of spreads, although this is true also of the underlying markets. Peripherals, and more recently the Sovereign, Supranational and Agency (SSA) sector have also been hammered.

So the main problem is that we have a lack of participation from real money accounts at the moment, for example, central banks who were buyers of some covered bonds such as Pfandbriefe and SSA paper. We are missing the real demand behind these assets.

Another problem is the repo market. After the Lehman Brothers collapse, the counterparty risk in the interbank market has significantly risen, and no one wants to face anybody in the repo market. As a result, the cash market has dried up and you cannot really offer bonds you don't have on your book, otherwise you face a very expensive repo cost.

So the problem is, if you cannot short some bonds, how can you deal with, and hedge, any selling pressure? As a market maker, you absolutely cannot hedge yourself; the only way to hedge is through CDS, though this is not necessarily effective. One consequence of this has been to put pressure on the CDS levels of certain banks, because this is seen as the only way to hedge your trading book.

IFR: So what does this mean for the covered product as a liquid instrument?

Poli: I am not sure there is a single market that is liquid, to be honest. Consider the swap market, which should be the most liquid on the euro side.

When you see 10/30s move from minus 25bp to minus 50bp in a single morning with just a couple of trades, it shows you the extent of the illiquidity of the market, and this is the best hedge we have for covered bonds.

IFR: So how easy or difficult has it been for the investor to offload positions?

Sayuri Aoyama (Morgan Stanley Investment Management): We are a fixed income portfolio manager and we are facing some redemption requests from investors in our bond portfolio. But the request is for a much more moderate amount than the amount relating to equities or some other types of investments.

However, in order to be prepared, we need to keep the portfolio liquid. So normally in our portfolio – which includes high yield, credit, covered bonds, government, and interest rate exposure – we have a 4% to 5% cash position. But then we try to have over 5% cash, sometimes even 5% to 10% to face potential redemptions. That's why for us, cash really is king.

Even though we are value investors, and even though in theory it really makes sense to have long positions in more risky markets such as in high yield, we need to manage the portfolio on a very short term day to day basis.

IFR: Presumably the repo situation must be, to some extent, the underlying root of the illiquidity problem. Paul, one of the broking houses I believe recently reduced its repo operation in London, which struck me perhaps as a signal that the market is not coming back any time soon. Would you go along with that?

Paul Guire (Icap): First of all, I don't think that reduction was anything to do with the market conditions. The repo considerations are not just relevant to this product. We are here to talk about covered bonds in isolation, but to echo what Nico said, the whole credit curve has been hammered – although some areas have fared far worse than covered bonds, and some, far less.

If you ask the question to any bond trader at the moment, "is the market liquid?" the answer is very categorically no, for anything, from government bonds to high yield.

The repo market was one part of the market which enabled banks to neutralise bids, which has now gone as it is not possible to borrow easily in the current environment. I actually heard recently that there are some situations in the market where borrowing has not been possible; deliveries are not even taking place in the repo market which is a dangerous development.

The words "buy in" have been muttered at least twice in recent weeks, which I don't think is a good thing to be hearing in this market. I tend to associate those types of issues with emerging markets and worse.

As you say, cash is king. But I think another underlying issue that we have seen as being very instrumental is that cash has dried up at the lending stage. Everyone is advertising the fact that Euribor and Libor are all coming down, but cash isn't changing hands at the official fixing levels.

Although enough cash is changing hands at those levels to make the number quasi-credible, real money is changing hands at somewhat higher levels – or even at lower levels, because you've got a massive discrepancy in money market trading levels. One institution with money to lend actually placed it around 30bp through Libid recently, as it only had line availability to one other bank. While others have traded as high as Euribor plus 10bp to 15bp, so the screen print for Euribor is distorting the market.

It was interesting recently when the Euribor rate started to come down as there was suddenly demand from dealerships, and probably end accounts as well.. as they thought "ah, money is coming back to the street".

They started looking for two to three year paper because that seemed to be where the governments were prepared to provide guarantees for certain asset classes. So the three year curve was better bid in pretty much all jurisdictions. There were only one or two names left out, but anything from the British names got looked at, to the Irish, to anything that was offering high yield.

Then the realisation was that actually, money rates weren’t coming down: Euribor was coming down but actual money transactions weren't necessarily following it. So we moved back to the realisation that the repo market is broken and you can't finance positions in the way that used to be possible.

Aoyama: Do you think at some point the repo market will come back? Because many banks are now under pressure with deleveraging, which means that repo, which was one of the tools to leverage up for the last three or four years, is changing in significance.

Guire: Yes, repo is a leveraging tool, but it is a relatively secure leveraging tool insomuch as the over collateralisation, the haircut, should ‘in theory’ be in place. I put the ‘in theory’ in quote marks because sometimes that is not the case and then problems occur.

I think it will come back, but it is a trust factor. It is not a question of, "am I prepared to lend cash against a security of 102%?" It is "am I prepared to give it to that bank, irrespective of the underlying collateral?" There are a lot of people that we talk to that only want to do central counterparty clearing repo, because of the security of the money being returned.

Aoyama: That is true.

Guire: If that is a development for the future, it'll be a good development, but there is [a] central counterparty and it is basically being swamped by demand. Therefore, the repo mechanism at the moment is broken, but just like everything else is currently broken. There isn't really anything you can identify that works correctly, or at least it did.

IFR: So where does that leave us now?

Christian Reusch (Unicredit): I think liquidity in general needs to be redefined going forward, and the liquidity we have seen for the last five years will probably not come back anytime soon.

This will have implications for investment decisions on the investor side. It has had large implications already on the trading side, because as you rightly said, if you cannot repo positions any more, then this has implications on the ability to make good bids and offers to clients.

So from this perspective, I think all involved parties in this process – investors, traders and issuers – need to define for themselves, what does liquidity mean?

Perhaps, going forward, if you want to sell huge positions, it may not only take not an hour, it may take two days, three days, or four days, if it is possible at all. I think that is what needs to be defined, and no one has a real answer to that.

As long as the money market is not really working, the repo market is not working nor government bond markets – with the exception of the on-the-run Bunds, though even that is questionable sometimes – plus the swap market. If those components do not work, how can you talk about liquidity?

Carlos Stilianopoulos (Caja Madrid): One of the key successes of the covered bond market was the liquidity that was attached to it. You take away liquidity; the whole covered bond market just falls down. As an issuer, we obviously cannot do that much right now. Basically we are still issuing private placements for those investors who don't care about liquidity. That is the only way we can act until liquidity does, to some extent, come back and the market does manage to react to the government measures, but we don't know when that is going to be.

IFR: So does this make the jumbo covered bond redundant?

Reusch: At the end of the day, this needs to be answered by investors. Investors, especially fund managers and those who need to have the ability to switch and to also offload positions if needed, will need to define whether they can live with the small to medium sized issues. Perhaps in the future we will sell €300m or €500m issues, and they can be as liquid or as illiquid as a €1bn or €1.5bn transaction.

I guess that this is not an isolated covered bond issue; this is a problem which holds true for all types of asset classes. The same could also be said of peripheral government bonds, such as Greece, for example.

Sebastien Gianfermi (BNP Paribas): I think that the problem we are talking about is the ability to repo; obviously the smaller the issue, the more difficult it is going to be to repo it.

So for me there are two concepts: liquidity is very important, but to get a very efficient market you also need to get a bit of stability. So stability brings liquidity.

In the past in the covered bond market, we have been trying to force the liquidity in what was essentially a one way market, and this has hurt a lot of people. It has created some acceleration of spread widening, and it has basically killed the stability of the market. If you kill the stability, you lose the liquidity.

So I think in the coming months there will be much more state guaranteed issuance, as we have already started to see. It will be one of the only ways for banks to fund, but after that, covered bonds are going to be a very important tool. I also think that you are going to see a lot of registered covered bonds, as mark-to-market is quite painful for customers, and Namenspfandbriefe and registered covered bonds are one way to avoid that if investors are happy with the credit.

Obviously with all the support we have seen from the European governments and central banks, a lot of concerns have been answered in the short term, and with respect to funding, the ECB is injecting a lot of cash into the market.

This means that it is now possible to basically fund long positions, but running short positions remain problematic, as we have seen with Euroclear threatening to call back some bonds because they couldn't deliver.

It is a big problem as you cannot trade this market from a long only perspective . The correlation between CDS, which is a derivative, and the cash market is broken. It is even broken in the senior market where basis swap levels have exploded. So it is not a good hedge but it is the only hedge available, although it runs the risk of not reflecting the movement of the underlying asset you are trying to hedge. Ultimately I think you need to sell big issues to provide a better hedge, which may be more difficult, but if you want to get liquidity you need to have decent sized deals.

I think what we have seen is to some extent stabilisation in the government markets over recent weeks. We have maybe overshot on some bonds in the widening process. But right now, even if it is trading illiquidly with a large bid/offer spread, it remains very visible. We are still seeing some spreads which are somewhat static at their wides, so that the bid is going to be rather far from the offer, but it is the same in govvies.

We are, nevertheless, still seeing some good business done even if it is, as you were saying, not as easy to sell a big block of bonds. You may have to work at it for a few days.

Reusch: I agree with what you say with respect to the guaranteed bonds, but so far we have seen only one in a reasonable maturity. The second is on the road as we speak. I think there needs to be some more guaranteed issuance and then we need also to see what the liquidity is like in these types of issues.

And also, I think there is a political willingness to force people, or at least those who have been bookrunners on the trades, to generate some liquidity, but we also need to see how this works. The vdp (Association of Pfandbriefbanks) also had the same nice idea some months ago following requests by investors who said "please make this product liquid again and start market making."

This was a nice intention, but clearly, in a market where there are hardly any bids around, if you start inter-dealer market making and showing bids, guess what? It will not take a week, it will just take a matter of hours or days until it comes to an end again, because if there is a bid and you are a forced seller, you will try for as long as possible to offload what you would like to get rid of.

Gianfermi: I think the issue is that a lot of customers are basically looking for cash. Even if they have lost say 500bp on a corporate, if you show them a bid on a covered bond, which is not so far from cost, they will take the loss on the covered bond. For them it is a cheaper option still to reduce government positions, after which they will then have to look at the next liquid asset, perhaps covered bonds.

Guire: I think that none of the three basic elements of the covered bond market – that is the investor, the issuer, and the secondary market in the middle – are entirely sure whether we have reached a quasi stable period, or a plateau, from which the current situation will deteriorate again.

Perhaps if some issuance was to come to the market in good size, the market will decide whether it is right or wrong. Take the Barclays issue, they have probably deliberately left premium on the table to test the water for this particular asset class, and if the HBOS deal also transpired to be a strong issue, I think you will see the gates open for other such deals. Then, an asset class of mid-swaps plus 20bp area in the two to four year sector will have been established.

So you can probably say goodbye to OePfa’s trading at mid-swaps plus 20bp. If each jurisdiction is going to say "its SOLVA 0%," then that is a benchmark, you have drawn a line in the sand.

But there will be some short dated interest which will keep prices tight in certain areas, then you can assess where the German curve starts and where the French curve starts. But it’s the Spanish curve that hasn't been disrupted in the last month. Once the panic selling was over, we stayed at these spread levels. You can quote with reasonable confidence around the outstanding AYT debt or the multi cedulas as a packet now and say, "well it will be wide, but you won't get into trouble". We as a broker are no longer hearing "get me out, get me a bid".

Gianfermi: I think we have moved away from the panic mode.

Guire: Yes. The covered bond market has actually entered a relatively stable period.

Reusch: But to turn it the other way round, if you have no problem with the underlying credit, and you would like to buy now at these wide quoted spreads, you will hardly get positions. Those who are loaned these bonds have probablyalready taken so much pain and do not want to sell at these levels.

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