Covered Bonds Roundtable 2008: Part Two
IFR: I think they are called "trapped longs” or caught at higher levels?
Guire: Well, there are some long dated bonds that are being called "bid to maturity" and "hold to maturity"! So for some end investors, the bonds are buy-to-hold, and that is not a good development.
The vdp’s timing of re-introducing inter-dealer market making was unfortunate – through no fault of its own, it ultimately looked appalling. At that point, at least the German part of the market was trying to stabilise, notwithstanding the story with Hypo Real Estate. Following that, the market tried to stabilise at the new level, when along came the government guaranteed bank debt, at a price I don't think anyone actually expected. Consequently covered bonds hit another repricing blockage as the market faces up to a potential glut of this new supply.
Recently there have been media reports that next year government debt is expected to be in excess of €1trn, with government-backed bank paper of up to €1.6trn. If this is anywhere near true, then it will be a bigger asset class than what we are talking about here in covered bonds.
Gianfermi: It is likely that you are going to see much more issuance from government guaranteed bank debt. We have already started to see it from the UK and it is quite clear that you are going to see issuance from other countries too.
So it is definitely providing a new floor for the high quality assets. We have seen a huge underperformance of peripherals in SSA's in the past few days. You can expect to see more new issuance, and consequently know there is not much upside on the better quality bonds. Then you will see a bit more pressure.
When you look at the valuation of some of the more distressed covered bonds, it is interesting to see the recovery rate linked to those bonds. Obviously we have never seen any default in covered bonds – even the Washington Mutual was bought by JP Morgan, though it is still trading as Washington Mutual!
Reusch: Good point.
Gianfermi: I think we are just in a price discovery mode, and there is a lot of dislocation. Cash restraints et cetera ensure this will remain for a long time.
Guire: At the moment it seems to be a process of push and shove. I think in the end the investor will decide on the fair valuation of the market, because they will get bored with waiting for new issues to come at the new levels. Investors are cash rich and sitting there with money to invest, but they're not prepared to put it to work until they see where valuations stabilise.
Reusch: It is still a chicken and egg problem. You have the issuer on the one side which is prepared, more or less, to do everything possible to make his transaction a success. You then have the investor, on the other side, who is not sure about the fair valuation of a potential new issue, and no one is moving first. So it is something of a problem; you would like to go ahead and have a certain spread but you may not find any reasonable demand at this level. It’s not easy to take the first step.
I agree that the guaranteed paper will probably be the name of the game for the next couple of months, or the alternative to very expensive government bonds. On the other hand, a lot of investors are also facing a problem with their duration management. From this perspective they are also seeking longer dated paper. So why not buy, for example, either a long dated covered bond, or a long dated senior unsecured? Should a five year Barclays non guaranteed bond now fail after having now been guaranteed up to three years? I would question that.
Soenke Siemssen (Bayern LB): I was wondering why this discussion is focusing so much on the traditional liquidity concept; I think that game is over and will not come back. Be pretty sure, but this does not mean that we will get private placements all over the place. Take a look at traditional brokerage. Up to now, the banks have provided an abundance of liquidity on their balance sheet – basically leveraging to provide liquidity to investors. This will not happen any longer. They will not be allowed to provide liquidity in that amount because there is no liquidity. They will be forced by regulations and balance sheet accounting rules to deleverage their balance sheet.
How can they deleverage? Well, they can get rid of all these financial assets they have, so traders will not get the limits and lines to build up a huge warehouse of bonds or financial assets. Instead, I think the market will move towards the concept of produce on demand, where the bank is going back to a brokerage type of model.
I always wonder as a fixed income investor and now researcher, why does the equity market behave so differently? In the equity market there is always a central clearing agent, so there is hardly any balance sheet involvement from the banks, there is just brokerage.
Even if you look at emerging market debt a couple of years ago, banks needed to know who had what position and what strategy real investors were employing. The bank acted as a broker between one real investor and another real investor, and if they didn’t want to trade, liquidity was their problem, not the banks’. I think the trading concept will change and we have to adapt the investment banking industry to this totally different way of trading.
From my traders, I see there is some turnover, in small amounts, and it can take some time to execute. It is a little bit like in the old times.
When I started in the 1990s, people told me how dealing was in the 1970s: you basically had to phone around and find out who has what positions. Finally you find someone with a matching position, and if it takes three days that's fine, it is not a problem. Real money investors usually do not have a problem with one or two or three days. For them it is more a problem if they have to unwind the position and it takes longer than two or three months. Therefore we should think not ‘how do we get back to the old way of doing things?’ but rather, ‘how do we proceed to a new concept of trading?’
IFR: So are we starting from the beginning again?
Gianfermi: That is a fair representation of where we stand now. I think that we will get back some liquidity, but the different banks will have a different approach. There will be a different way of trading from banks with capital, to banks acting more like agency brokers.
I think that if things start to calm down, banks may not put as much capital to work as they used to. As you said, they may be forced not to, but when you consider that you have over a €1trn of covered bond debt outstanding, you need to put capital to trade. Otherwise it is not going to be a liquid market any more.
Siemssen: If the capital requirements increase tenfold, twentyfold, then how much can you trade on that increased capital requirement?
If capital requirements are increased for trading positions, it is very unlikely, that traders will be able to hold large positions in future. It will simply be too capital intensive.
In order to give you some idea about the sharp increase capital requirements considered the EU proposal for interbank lending: Risk weighted lending should be caped to 25% of equity - or alternatively €150mm (which is for large banks much less than the 25%). Covered bonds have a risk weighting of 10%. That does not sound much, but if you add your positions up (money markets, swaps, senior bonds and covered bonds) you will soon reach the limit.
My estimate is that trading positions will not recover to more than 10% of pre-crisis volumes.
We have this inclusion in Germany into the covered bonds, included in the interbank position limits. I think we are allowed the EU is planning to have 25 per cent of equity and risk weighted assets to each bank. Covered bonds were included with a 10 per cent risk rate.
Well, see how much position you can take on that one. It is still bank debt, and capital requirements will increase. The bank will assign capital to trading, definitely, but the amount you can deal on that capital will be one tenth of what you used to.
Reusch: It is more anachronistic than what we are currently seeing. In 1995, when the jumbo market was created in Germany, it was created because investors were fed up with the illiquidity of the DM20m, DM30m, DM50m deals they bought in Deutschemarks at that time, and the inability of banks or issuers to provide reasonable prices.
They therefore requested that the issuers provide the market with a liquid instrument, or they would put money to work in other assets. This is what led to the establishment of a benchmark transaction, as it worked well with the sovereigns and agencies of this world. Now we are facing a different liquidity scenario.
I agree that the liquidity we have seen in recent years will not come back in a short period of time, and maybe never. But at the same time I do not think that this answers the question of whether we will still see benchmark trades - defined as €1bn plus. Yes, we will see them, but it is probable that smaller to medium sized transactions will also work, as long as the investor is assured that those banks which have provided such transactions in the primary market will also provide a secondary market. This does not necessarily mean that we quote ten-years on a 10ct bid offer spread. I think that is clearly nonsense.
Rupert Warmington (TradeWeb): I think the key issue is how we go back to finding a level of liquidity going forward. Liquidity may be market driven, such as moving more towards something like the corporate bond market, where there is an obligation to quote on an issue that you have lead managed. Or you could see a rules based structure being imposed, where it is dictated what bid offer spread you will quote and in what size. It is a question of what is the right approach to get that liquidity going again.
IFR: Rupert, I assume that you see Investor flows going through, and you must have seen a change in the way that those flows are being executed? Have you witnessed any disparity in the response from the dealer community to investor requests to bid an offer?
Warmington: Absolutely. Dealers are much more wary of who they give liquidity to. There has been a big disparity between the different asset classes within the covered bond world, where they are prepared to give liquidity. I don't think that is any secret.
We are fundamentally an institutional real money platform; the majority of our volume is based on that, so we haven't seen any new investor base come in. We have, however, to some extent, seen a one way flow of people trying to get out, and I think there is a whole class of investors who were involved in the market, and fairly heavily so, who are strongly questioning whether they will be there again.
IFR: What is the time limit for the request for price?
Warmington: Two minutes. I was looking at the difference in time to quote figures just this morning. That actually hasn't gone up too much. We looked at it in October last year compared to October this year. The average time to quote has in fact only increased by about five seconds from 15 to 20 seconds. So I think people know if they are going to quote or not relatively quickly. It is just there is a lot less willingness to actually do so.
IFR: Are you seeing a correlation between the size that is being bought or sold? Is there is a correlation between that and the promptness and the ability to put prices forward?
Warmington: I think investors are less willing to try and do large amounts electronically now, which will come as no surprise. Again, like the corporate markets, a lot of the larger sized transactions, when they can get done, take a lot longer. We have seen a fairly big reduction in the average size of trades, though not necessarily in the number of trades going through. We obviously do not have much visibility into what is done over the phone, but I am led to believe that there is nowhere near the size of trades going on than there previously was.
Gianfermi: Would you say that investors have changed the way they trade? For example, they used to use six dealers as a maximum?
Warmington: It is four currently, but generally across the trader platform it is five. Initially we saw the heaviest change in that you can ask, say five dealers, while maybe 18 months ago people would be asking three and a half on average. As soon as illiquidity came back then they went to all five, then I think relatively quickly realised that they weren't doing themselves any favours and so actually came back towards that three and a half number. In fact in some markets it is slightly less than it was before.
IFR: Sayuri, what is your perspective on this from the investor side?
Aoyama: Whilst I think the money market needs to be very liquid, and liquidity within the fixed income fund is also important, our fixed income portfolio does not necessarily need to be as liquid. We actually changed our portfolio strategy very recently as we looked to put more weight on bank senior debt and covered bonds. Of course, cash is very important, but then our focus is now actually shifting from the bank sector to credit default risk at the moment. And then we looked to take advantage of the financial sector, and so we are overweight in bank senior and also covered bonds.
But where covered bonds are concerned, the comparison needs to be made between guaranteed bank senior and covered bonds. At this moment the guaranteed bank senior debt is cheaper than the covered bonds, so we would rather invest in that asset class.
Guire: But it is not cheaper than Spanish!
Stilianopoulos: You haven't seen the Spanish government guarantee yet!
Reusch: But isn't it a problem as an investor that in the last 12 months you have probably not had that many opportunities to buy a paper longer than three years? Of course you can manage your duration with long dated government bonds or other instruments, but is it not rather boring if you don't have problems with the credit itself, to always be looking at the very short end of the curve, even though it may look cheap.
Hermann Maschl (Hypo Investment Bank): But is that not the potential future of the covered bond? You do have duration considerations, and as an issuer, especially on the public sector side. I have to consider that I do have maturities of 20 to 25 years on the asset side. So it is very obvious to refinance not in short maturities, but in long maturities, and it also guarantees that liquidity comes back in time.
Reusch: And you also will be forced by your regulators, because they would like to see duration matching in your asset liability management.
Maschl: Exactly. So for the last year or so, the covered bond has been used as a very short dated funding instrument, partly because of the credit spread curve. But it could be considered, in hindsight, that it was a wrong direction, and that now longer maturities that give back this duration matching criteria could have been a way to gain more trust. We now have a new milestone as those short maturities such as three years are guaranteed, and they are being issued at mid-swaps plus 25bp. Pfandbrief simply cannot compete in these maturities.
But repositioning the covered bond as a long dated financing instrument could be something that actually helps the market, but first, the root of all problems has to be solved. This is not the long maturities but the very short maturities, as long as banks are not willing to give other banks money for longer than overnight lending.