Covered Bonds Roundtable 2008: Part Three
IFR: So have we seen banks use covered bonds more for liquidity purposes than for the financing of assets?
Stilianopoulos: It is a mixture really. In the last 12 months we are using covered bonds for funding purposes, certainly. Up to 12 months ago it was the contrary; we were doing 10, 20, even 30 year covered bonds, basically to match with our assets.
It has been mentioned that covered bonds should be very long dated, and perhaps, that is the niche they had in the market. However, when we did our 10 year plus issues, the truth is we lost many investors along the way, because most of the investors who were actually buying covered bonds were only buying up to five years. From five years onwards it was a different type of investor, so the sizes weren't as large. Perhaps the niche for this market will be for long dated paper, but we will miss a lot of investors if we do that.
Guire: Three months ago there was very little sub five year paper in large blocks available in most jurisdictions. There was strong demand from end investors, such as central banks, end money accounts and money funds. In the sub two year sector, it was almost impossible to find any paper at all. Following the Lehman collapse, people realised we are not going to avoid a liquidity crunch and we are not going to avoid a short end funding crunch, which is what we have now seen. Everybody wants to reduce short end exposure because there's no money available to fund it. All the models that everyone was playing against – Eonia or against repo – are broken as well. The links in the chain are broken.
What it has done, and we have seen it in the agency curve, is force the back end of the curve up as well. I hear a lot of people saying that, sooner or later, when this part of the cycle is over, the long end is going to look attractive, and that includes covered bonds as well. The curve has effectively been inverted for the last three months.
Gianfermi: Before, people were looking at the front end because of the swap spread. Two years were trading at 105bp when the 10 year was at 50bp, so in terms of spreads to governments, it was quite interesting.
But the longer end has been somewhat protected because of low issuance in the past year or so. At the same time, there is no real demand in the long end. The only demand we saw was from dealers who were basically looking to buy back some or shorts that were costing them heavy in the repo.
And sometimes they couldn't even fund themselves, because after the demise of Lehman, the availability of many issues has diminished. It means it is difficult to borrow stock in order to be able to cover short positions.
But, as Carlos said, the investor base in the long end is much smaller than the investor base at the front end. You are losing the central banks, and though you are gaining insurance companies, the overall appetite for covered bonds has diminished in the past year in any case.
Warmington: Is that not going to be a factor anyway, that you are going to lose central banks as investors in the medium term, so you have to go and look for other candidates?
Gianfermi: I think that they may reassess their appetite for covered bonds, in that previously they were heavily loaded with public sector covered bonds which have been under the spotlight in Germany and France, for instance.
Aoyama: We are not a central bank investor. For us the rationale of making an investment is driven solely by economic considerations. If a short term covered bond is issued by a bank with a short term sovereign guarantee offering an attractive swap spread, this will be more attractive for us than a longer dated issue offering an equivalent spread. In other words, it will make sense for us to buy the shorter dated issue, assuming no additional credit risk is involved.
Guire: But I think if public sector debt finds a level in the market, it is unlikely that will be at plus 20bp. It is more likely to be somewhere above that level. The central banks can also argue with themselves, what the price is now compared to previously. We didn't have the option of government guarantee then, although we do now. The government guarantee is somewhere between 15bp and 20bp. If you look for Obligations Foncieres compared to others at plus 35bp–40bp, I will make my decision based on the value of the trade now, not the historic rates that were sub Libor.
The problem is there is no guidance available from new issue levels. If one of the larger higher quality German Pfandbrief names or one of the French Obligation Foncieres came to the market and accepted the repricing with a three, five year or even a seven year maturity, I think the market reaction would be positive.
Warmington: Isn't the level of secondary liquidity going to be a key factor if the central banks stay in and all goes well in the asset class?
Reusch: However, they have the problem with a lot of other instruments in which they have been investing in as well. We are always coming back to one key point next to the credit itself where we need to be comfortable with, liquidity.
I think at this stage no answer can be given. Each individual investor needs to answer himself for what benefit he is investing. If the investor is a fund and has a lot of outflows, the ability to liquidate on short notice is essential. It is as simple as that.
This will also determine their business going forward with respect to the asset classes they are able to invest in and find fair bids if needed.
IFR: Can electronic platforms, interdealer platforms and voice brokers assist two way trading?
Guire: How can a voice broker provide liquidity? We can't take a position, so we can't provide liquidity. We can only provide liquidity if we are given the liquidity by a bank. What we can do is provide ideas and facilitate flow and provide flow ideas, but we can't provide a market because that comes from our customer base.
Gianfermi: I think in the current market, you have to be a trade facilitator. Obviously information is key. Electronic trading is not efficient right now. At best you are going to have a very wide bid/offer spread in very small size, which is never going to be traded because the buyer will not meet the seller. Where it will bring added value is that you will invariably be speaking to the right guy. You will know who to speak to, who is the real buyer and who is the real seller, and you may find a trade in between.
Guire: But the question was "restore" liquidity. We can't restore liquidity, we operate to facilitate liquidity.
Poli: It is the same with Italy and Greece. You have two way prices on the screens, even very wide bid/offer spreads. Greece has had a point bid/offer, but at least you know where the market is. It doesn’t trade but then it is the role of a voice broker to trade inside that. It is your role to say, look, this is the market, one point bid/offer, this is definitely too wide, but I have interest to sell here.
The role of the broker is to know who is short, who wants to cover this position and then to match. That is how it works.
We should have that on covered bonds. We can't do that at the moment because unfortunately we don't have the real money buying our product because they face mark to market – a real problem for them. We all know that they are working on trying to suspend the mark to market. HBOS covered bonds are yielding 15%. This is seriously crazy.
Guire: I think it comes down to what the banks have to spend on the product. At the moment the voice broker is the prime source of price discovery, information discovery, and then position avoidance, in that order.
Siemssen: I think that the voice broker is central to getting back to liquidity because in this crisis, we face the situation that transparency is actually a bad thing.
Siemssen: In a discussion with the European Bond Commission the economic concept of game theory was raised, which can actually be used to explain why transparency is bad. The voice broker provides a market with less transparency. Electronic trading platforms meanwhile provide too much transparency, and therefore support a herding behaviour because they are too transparent for these market conditions. This is more a theoretical issue of course, that needs to be analysed. In the coming years I think you will see lots of discussions about this issue. I think the voice broker is the central instrument in the market to get back to some level.
Guire: I think the market will go back to some level of basics.
Siemssen: There is another point which has not arisen here. My experience as an investment manager is that people who buy covered bonds are very conservative people. That is why they don't go into financials or corporates.
The ECB is now going to reinstall steep credit curves. And the steep curve that matters to the market is the Libor swap curve. If we say ECB reduces rates to 2% and we have 3% Libor, or 3.25%, and you get covered bonds in the five and ten year sectors at 4%-5%, you will see real money investors return.
Why would you invest in five or ten year bonds if you get more in three years? So the ECB has to reinstall steep curves. Then you will see real money accounts coming back.
It is a traditional theory: steep yield curves are good for the economy because they initiate long term investment.
Warmington: It also helps to recapitalise banks' balance sheets. That is the key thing.
IFR: I think that is the main point, that it recapitalises balance sheets.
Maschl: One of the theories behind why the yield curve is shaped as it is relates to liquidity preference. You will typically want more income on longer durations, so maybe the concept of getting back liquidity is to start from the beginning and offer less compensation for shorter maturities and more compensation for long maturities.
IFR: Well, we should move this on to the primary market now. Book building in the new world: has the way that issuers and bankers approach the market changed? Is there now an element of price discovery?
Stilianopoulos: I think for the most part that we will have to wait and see. It has been mentioned before that we have to assess the impact of the government guaranteed bank debt; we know there is a lot of that paper coming to the market.
I think once we have had this supply out in the market it will help maybe to reopen other markets such as covered bonds and senior unsecured, but this asset class needs to establish itself first. If these new deals coming out today really are finding good placement, as seems to be the case, then investors are reacting and reopening the market.
But when will we see covered bonds again? Probably not for a few months.
IFR: That long?
Stilianopoulos: Yes. Obviously we are still visiting investors and we are still doing roadshows, but we will basically do private placements until we believe the public market is open again.
IFR: Hermann, you are marketing your inaugural covered bond? Do you share Carlos' sentiments?
Maschl: It is a totally new and totally challenging environment, and I think whenever there is such a challenging environment, we just simply have to reconfigure our opinions and try to find new ways of solving these problems.
We simply do not know where such bonds could be brought to the market. We also see possibilities in terms of private placements. But, I wonder whether the covered bond market would come back quicker if there was a guarantee on this asset class as well, maybe for the longer durations?