Covered Bonds Roundtable 2009: Part I
IFR: Last time we had a covered bond roundtable there was a very negative outlook in general terms for issuance, which arguably extended to other sectors of the market as well. There was certainly a point last year when covered bonds just were not being issued for a long period of time.
Anders, you're an issuer: how did you see the ECB intervention and how did it help you reformulate your covered bond programme?
Anders Kvist, SEB: SEB was one of the first issuers to try and issue in the first quarter of this year when the markets were still quite disrupted. It was a token of our commitment to the market that if the correct spread, the clearing spread, was 130 basis points, we would issue at that level, even though in retrospect it may seem to have been very high.
Along with the Swedish authorities, we were lobbying the ECB to have non EMU country covered bonds included in the purchasing programme. We knew the odds were slim and we didn't achieve our goal, but I always took the view that, indirectly, the non EMU covered bonds would benefit from this purchasing programme – as, indeed, they seem to have done. We have seen a positive, though indirect, effect on the spread. The primary market opened up for the countries included, as well as Sweden. So I think the ECB programme had a significant impact in terms of sentiment.
IFR: Fernando, as an issuer, your covered bonds are included in the programme.
Fernando Cuesta, Caja Madrid: Yes, they are.
A year ago investors were still very nervous. Some of them were more interested in government guaranteed bonds. The ones that were not interested in government guaranteed bonds (GGBs) wanted more yield. They had senior unsecured bonds paying close to 200 or 250 basis points in some cases. Covered bonds were in the middle of nowhere, seemingly not as safe as had been thought and with no market makers providing liquidity – and often unable to provide it. They'd lost part of their appeal.
I think the ECB really restarted the engine. Of course, the support the ECB gave covered bonds is temporary, but there is a feeling that if a similar crisis happens again in the future, there may not be more GGBs but we would see the same kind of commitment repeated for covered bonds. GGBs will come to an end at the end of this year for most jurisdictions. Perhaps there will be a quarter or two quarters more in 2010, but I think if central banks need to support private banks in the future they will do it with covered bonds.
The programme has really restarted the market. The ECB delayed its buyings recently but it did not affect the primary market. It has even lifted issues with extended duration: the recent Unicredit transaction – a 12 year – and the Barclays 10 year issues show investors are interested in maturities that, at the beginning of the ECB programme at least, were not included – or were supposedly not included.
Central banks' participation in primaries has been steadily declining. So its first target, to restart the market and push it up to levels that should be stable, has been achieved. Of course, we'll have periods of sharpness: the supply we had in September was amazing, and we have seen a widening trend in the last two or three weeks, but we do have stability and I expect we'll see again a tightening trend from here on. From the spread level of 100 basis points we saw in the beginning of September, we should get to a level close to 60 or 70 basis points.
IFR: There was a distinct pick up in activity on the day of the ECB announcement. Does this mean one or more participants in the market were aware that the covered bond purchase programme was imminent.
Allen Rad, RBS: There was some talk about it before the announcement. There was a sense the ECB was going to do something. A researcher had written about it two or three weeks before the announcement, but that didn’t seem to create much activity. The market was already in a tightening mood, the ECB merely acted as a catalyst. The covered bond purchase programme was essentially an advertisement from the ECB for the whole market. Before 2006 or 2007, we typically had 60 or 70 accounts that would be interested in a bond issue in the primary market. Now we have 120 or 130 accounts showing interest. That shows the ECB is doing a pretty good job for the market. For us it's a free advertisement and we are all enjoying it.
IFR: Paul, you're in a privileged position with respect to seeing flow. Did you see a pick up in activity? Certainly people we spoke to around that time observed a much busier market prior to the ECB announcement.
Paul Guire, ICAP: Certainly the month before, there appeared to be certain jurisdictions that were in the know. There was a big tightening in certain categories – and no tightening at all among German credits. Then on May 5 the market picked up in activity. It was unfortunate for the shorts: they were the cause of the activity but suddenly found themselves stranded. They, more than anyone, didn't expect the announcement to be as explicit as it was. Then there was the delay, between the announcement and the full disclosure of the details, which effectively closed the market for a month. That was also unfortunate from the shorts’ perspective.
When the ECB came with the full announcement and all the details, it made life very difficult in the secondary market, which has been one unfortunate side effect. The secondary market had been starting to recover and there was some activity, but the announcement killed it.
IFR: Was it too much? Too sudden a market tightening, from one extreme to the other? It went in a few months from not being able to find a bid to not being able to find an offer, effectively. The bottleneck actually changed in the market.
Guire: It tipped the bottle up, maybe.
Tim Skeet, Bank of America Merrill Lynch: We still have a situation where the primary market price is the secondary market price. That's the situation we've had since last year. It's peculiar because we've never really had that before. Throughout the crisis the thing that really struck me from a trading perspective was the sense that there was no direction, no relative value, for the cash traders.
I disagree with what you said at the beginning to some extent, the way you isolate covered bonds. Yes we are here to talk about covered bonds but the whole market was blown off course and the covered bond product was just one among many affected. The SSA curve survived a bit longer into the early part of this year but then that blew up too. Every single asset class got hammered.
Yes, last year was characterised by pessimism. Some of our friends on the research side were being extremely gloomy. There was a conference in Paris that felt like a kind of suicide mission for many people who were there. It felt like we were trying to stop people jumping off the bridge and off the Eiffel Tower! But look, we succeeded: people didn't jump and we're all back here to tell the tale.
The interesting thing is some of us were saying last year, "if one asset class returns to form it's going to be this asset class." Anders, you're absolutely right, you jumped in early because you believed in it. The Germans believed in it and the French believed in it – and that was prior to the ECB announcement.
We have to step back and look at this in the cold light of day, remember our history, which has been lost in the tumultuous intervening months. This asset class was already on the road to recovery before the ECB stepped in. The ECB’s action opened it up and allowed Spain to come in as an issuing country again, allowing people outside of the Franco German axis to come back into the market.
The next challenge is where we go when the ECB withdraws. I still feel pretty confident about it but we do need to think about how to get the secondary market back. That is the next thing we need to get our heads around.
Daniel, you guys were sitting on some pretty miserable underwater positions last year, but now you've ridden it back up. Those who kept their nerve should be feeling good about the asset class, and have a bit further to go by historical standards. Are you happy with that?
Daniel Loughney, Alliance Bernstein: You raise very important and good points. I'm with you – but not totally. Going back to where we were in Paris, we recognised the quality of the asset class, that it was superior to senior debt. But the big problem at that point was fund managers had losses on big positions that they didn't want to crystallise. The trading side didn't want to trade or leverage issues. This is where the ECB was effective.
The ECB has been effective in getting the spreads in, stimulating the primary market, buying in the secondary market and compressing spreads. It has not been effective in terms of making market participants speak to each other. There are a lot of bilateral trades going on between the ECB and portfolio managers, but the communication between the portfolio managers and the traders seems to have broken down compared to what we saw two and a half or three years ago.
Perhaps the covered bond market would have recovered on its own. I welcome the ECB programme and acknowledge it's had an effect. But liquidity remains a big issue. I think two thirds or more of the ECB’s intervention has been in the secondary market. The primary market is not an issue. The big issue as far as I am concerned is how we can bring the people in the market together again.
Guire: For me the ECB’s big mistake was mentioning its target of one year, or €60bn in one year. That led people in the market to sit with their calculators, trying to second guess what it would do. People estimate, “okay, €203m behind schedule to date, I won't sell anything until they're back”.
Skeet: To be fair, politically, the ECB had to put a cap on it. The good thing about the ECB is it said virtually nothing; it left it all up to our wonderful imaginations, which were working overtime in that period.
IFR: Was that a clever strategy?
Skeet: A very good strategy.
Rad: Yes, I think it was. Other central banks that were more specific about what they intended to buy saw those bonds move massively tighter immediately after the announcement. The ECB was more general and so the impact was felt across the whole curve. You do not see specific bonds trading significantly below their credit curve just because they were bought from the ECB.
In September, despite that month seeing the biggest primary market issuance levels, the ECB purchased two thirds in the secondary and one third in the primary market. This encouraged customers like bank treasuries - that had a long history with this product - to take the opportunity to sell directly to the ECB. That helped the market because it kept the traders balance sheet small, allowing them to come up with more aggressive prices for the customers who do not directly benefit from the ECB
I imagine it was the best year Paul has ever had as an inter-dealer broker. Before the good old days and the market making commitments, where we made bid/ offer spreads of ten cents, our turnover would be something like 70% versus market makers and 30% versus investors. These days, it's the other way round. Traders are much more client focused in what they do. The turnover on the B2B side is mostly going through brokers and nowadays, most liquidity is provided for and by customers.
I like to say covered bonds used to be a rates product with a credit element. Now it looks like a credit product with a rates element. A lot of credit departments are putting covered bonds into the credit side now, which make it less easy to provide the same size of balance sheet for it.
Skeet: That’s the fault of the rating agencies.
Michiel De Bruin, F&C: From an investor point of view, if you look at secondary market liquidity, there has been an improvement. Looking back, everything was screen based and when the screens went blank – even if there were very good reasons why they went blank – there was no clear back up. The market was very confused. Everybody was used to mandatory market making and that is something else that needs to be thought about going forward, in terms of what would happen if something like this were to occur again. Now people are picking up the old fashioned phone and calling around.
Guire: People are not embarrassed by their positions any more.
De Bruin: Yes, but maybe it was also a one way street. Investors now have better liquidity but we still play quite a large role as a price giver. We are very important in the price discovery process. In my opinion transparency still has room to improve – indeed, it needs to improve.
Skeet: Are you a member of any of these forums being operated by organisations like the Securities Industry and Financial Markets Association and the European Covered Bond Council?
De Bruin: We're in contact with them, yes.
Skeet: Have you joined the Covered Bond Investor Council yet?
De Bruin: We're in contact with them.
Skeet: That's where that debate needs to be hammered home.
De Bruin: Only with the investors, you think? It is important for the whole market. Take ICAP, for example: we cannot see their prices. For a bank, I imagine that is a problem. But purely from a transparency point of view, it would be interesting to see that change.
Rad: The committee is very important.
In terms of liquidity in German, French, and among strong Spanish names, the spreads tightened substantially so people feel more comfortable about showing two way flows. At the same time around 80% of the prices we are sending to customers via electronic platforms are tighter than the offers we have on the screens.
On the turnover side, as a trader I do not get the liquidity I provide to the customers from the market. The prices are much more aggressive than what I get from the market. Customers do normally get a tighter price for most of their enquiries. Outside Germany and France and those stronger Spanish names it is different, but this is also improving.
De Bruin: We've noticed the same thing but we still play an important role as a price giver. There's still a focus on axes and that is okay but it's not a complete picture, it is not transparent enough.
Skeet: Are you worried that all these bank capital regulations coming in will strangle the supply of capital to the trading desks, your counterparties? Do you see that beginning to happen, or do you think it is going to happen?
De Bruin: Not yet because liquidity has improved. It might in the future.
Loughney: Should that not divert more resources to covered bonds? Obviously we don't know what these regulations will be; they're not set in stone. But the understanding is that the capital weighting for covered bonds will on average be lower than in the past. That should make them more attractive.
Skeet: It should but the Basel rules are a bit complicated.
Loughney: Yes, they are.
Guire: We've found it more difficult in the secondary market in the past three months than the previous nine months. With the market makers effectively shut down, the only way to get paper moved was via the broking houses. Now it seems the banks are more aware of where prices should be, and are keeping their cards much closer to their chests. They're willing to move positions at a certain price, or they can sit on positions longer than they could – say in the first half of 2009. Did the ECB help that? I'm not so sure it did.
I agree with Allen, liquidity is still restricted to the big two Spanish banks, the German banks that haven't had troubles, and the French names. Beyond that some Scandinavian names will trade reasonably well although most of the rest of them are still a bit sticky. People don't like to ask questions about those bonds. I mentioned embarrassment about positions before: if somebody has a sticky position that they need to shift they don't necessarily like to mention it. They say, "get me a bid in this but maybe I won't sell it." It's a difficult environment.
Rad: At one point, around November / December last year, we saw agency brokers who were talking directly to investors being much more active. This has changed in the last few months, due to the fact that customers are again asking banks for competitive pricing.
There is also still a problem on the new issue side. September was very active for the new issue pipeline. Everyone wanted to take risk in covered bonds, without looking at what they were buying, and they were subsequently issued at very tight levels. Some of them widened up to 20 basis points over a short period - we've seen that in some weaker Spanish names without large turnover. It was fascinating how fast it was happening, despite the momentum created by the ECB.
Skeet: We're dancing around the issue. You mentioned the dreaded words: "Rates product or credit product?" We need to redefine what the market is because we're actually still a pseudo rates product which is credit tiered. It's a hybrid of what we used to have. We need to redefine it. Is it going to reverse itself? We came out of a product which was homogenous, regardless of issuer – the variable being nationality – with everything within a tight band of a few basis points. Now suddenly we have a big spread and a lot more credit, yet we're still talking about something that behaves like a rate product, if that term is still relevant.
Click here for Part two of the Roundtable.