Saturday, 22 September 2018

DCM 2007: Looking for answers

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As investors continued to handle everything mortgage related with asbestos gloves, some contagion from the liquidity fallout was inevitable in the covered bond market. But was the extreme widening witnessed in some jurisdictions justified? Rachelle Horn investigates.

As recently as three months ago, the covered bond brand was in the midst of its relentless campaign towards world domination. In what was undoubtedly an issuers’ market, the bullish conditions frequently gave rise to heavily over-subscribed books and record-tight spreads. But the picture is vastly different today.

The mid-summer new issue stagnation and liquidity crunch resulted in one of the most challenging environments ever faced by covered bond professionals, who, up until then, had been content to position the product as an ideal rates proxy. But now, with investors continuing to handle anything mortgage-related with extreme caution, the notion of whether covered bonds sit in the rates or credit camp has seldom been so brutally tested.

At one point during the summer, the covered bond market was clearly on the ropes. A tangled web of a diminishing new issue window, continuing headline risk and a persistently illiquid secondary market resulted in some questioning the role of market-making between inter-dealer bankers. As at early October, traders continued to shun the MTS platform, but the views on whether head-to-head market-making was the root of all evil differed markedly.

And with individual jurisdictions showing notable differences in their secondary performance, the question of market-making and liquidity is still a popular topic.

"Clearly, in a stable environment, market-making can be viewed as something that is conducive to spread performance, but in the other direction, we have seen the hot potato effect in newer or more-liquid bonds, which has in turn led to an exaggerated spread widening and volatility," surmises Derry Hubbard, head of covered bond marketing and execution at BNP Paribas.

But, as analysts at SG CIB point out, "when abundant liquidity breeds excesses and tight liquidity exposes vulnerabilities", it is little wonder that Spanish and UK covered bonds have been trading at levels which four months ago, would have been inconceivable.

So phenomenal have been the differences in performance (see graph) that credit quality or headline risk alone cannot account for the discrepancies. While almost all agree that a differentiation between covered bonds and jurisdictions was necessary and correct, Fritz Engelhard, a covered bonds strategist at Barclays Capital presents the following perspective. "In our view, the spread differentiation in covered bond markets mainly reflects; a) how heavily recent and expected supply was pushing the minimum selling price of market participants lower; b) how actively the respective bond was traded before the break-out of the liquidity shortage in the global money markets; c) how familiar covered bond market participants were in assessing the relative value of the individual product and; d) how heavily the typically strong demand from bank investors was dragged down by the overall liquidity shortage.

"Clearly there have been negative news flows. In some areas, such as the UK, such negative news flow re-enforced an already prevailing momentum towards the spread widening.

"However, the importance of the non-credit related factors can be tracked by the respective spread moves. Those bonds suffered from a stronger spread volatility; a) which were issued by frequent issuers with strong issuance activity in the past two years and a substantial pipeline; b) which have been more frequently traded in the secondary market; c) which were subject to a complexity/novelty premium and; d) which were particularly appealing to bank investors in terms of duration, spread and risk weighting."

Engelhard adds that it is important to identify the sources of liquidity and, in particular, to differentiate whether liquidity is driven by a dysfunction in underlying hedge instruments or related to covered bond-specific themes. "It is crucial to remain flexible with regards to bid/ask spreads, as this is a critical element to ensuring that the market receives the right signals for different instruments at different times. Low liquidity should not be mixed up with low quality. Indeed, this becomes obvious when we shift the focus from the situation of supply overhang to a situation of supply shortage," he says.

Bernd Volk, covered bond and agency strategist at Deutsche Bank points out that the moves may have been overdone and, in some instances, were triggered for the wrong reasons. "The worst performers have been the UK, US and Spain. In our view, the housing market, issuer credit quality and, in the case of the UK and Spain, also supply concerns as well as the lack of a strong domestic bid, have been the main reasons," he explains. "We saw ongoing demand for German Pfandbriefe and the comparably small spread widening was used to buy in. But from a fundamental perspective, I would have expected Nordic covered bonds to perform even better than they did.

“Also, some UK issuers got hit too hard in our view. Yorkshire Building Society's November 2011s traded down to mid-swaps plus 46bp." By way of comparison, Yorkshire priced its May 2010 issue in April at mid-swaps minus 4bp. "In Spain, some Cedulas Territoriales widened almost as strongly as Cedulas Hipotecarias: this was not justified in our view."

Jose Sarafana, senior covered bond analyst at SG CIB says that he believes the underperformance of Cedula is driven more by first-half supply factors and global liquidity considerations. "German banks are less profitable than their Spanish counterparts, so if spread moves were dependent upon credit quality, Cedula should have outperformed Pfandbriefe and not the other way around. The high supply of Spanish covered bonds in comparison to Pfandbriefe means that the former move more in line with market developments. Also, some market participants assume a strong real estate correction in Spain," he says.

Meanwhile, the ‘safe haven halo’ bestowed on Pfandbriefe and Obligations Foncieres market proved its worth. "German Pfandbriefe and Obligations Foncieres widened only slightly," explains Volk. "Hence, covered bonds based on a strong legal framework with a long history have only been slightly hit by the liquidity crunch." He also points out that unlike Spain, France and Germany benefit from a strong domestic bid that has also supported spreads.

Meanwhile, the story across the Atlantic remains unclear. "We are positive on all market segments with the exception of US covered bonds, which will probably remain pressurised for several more weeks because of their national origin alone," explains Sebastian Sachs, a covered bonds analyst at DZ.

So with headline risk continuing to make a weekly appearance, what can the major questions concerning the future revolve around what spread levels will bring back investor confidence and how far spreads will widen in the interim. While the questions are self evident, uncovering answers is nigh on impossible.

"We remain cautious on the further spread development and expect that the spread differences between Pfandbriefe and Obligations Foncieres and Cedula and UK covered bonds will shrink over the coming months. Secondary levels of Pfandbriefe and Obligations Foncieres will move closer to their current wider levels while UK covered bonds and Cedula have out-performance potential, in our view," says Frank Will, a frequent borrower strategist at RBS.

Supply matters

The bullish undertones of January also brought with it the expectation that 2007 would be another record supply year. Most now, however, have cut their expectations drastically.

In particular, Spanish Cedulas supply will likely fall short of previous estimates and, although Q4 is expected to bring some relief, the mortgage problems are likely hinder volumes in comparison to the same period of 2006.

Total Jumbo issuance September was €10bn, of which €7bn was issued in the last week. "Extrapolating this trend into the last three months of the year, new issue volumes for the rest of the year could be in the wide range of €30bn (three months with €10bn) up to €70bn (10 weeks with an average of €7bn),” says Will.

Will explains that any serious estimates at this stage will be very difficult as the actual volume will depend on a number of factors, not least the lasting recovery of the issuers’ other funding channels. "At the moment, it seems as if the markets for senior and subordinated bank debt as well as securitisation have started to recover, thus reducing the need for banks to use covered bonds. However, it is still not clear if and for how long this recovery will last."

Meanwhile, he says, new covered bond issuance will also depend on the disciplined approach and orderly behaviour of the issuers. "Investor demand seems to be solid right now but there are a huge number of covered bond issuers in the pipeline. The large majority of covered bond issuers currently still have sufficient liquidity left but most of them will have to come to the market at some stage. We believe that the supply and demand balance is still very fragile. Any massive new issue wave would hurt the secondary market and might force the primary market back into idle mode. Finally, any new credit blow-ups would harm investor demand and would make it more difficult for issuers to tap the market."

Should the primary market stabilise, Will expects a new issue volume of about €40-€50bn going into the year-end. "However, we believe that the market is still very fragile and fear that the current delicate demand and supply balance can be easily destabilised. Any amount significantly above the €50bn level will put covered bonds under pressure.”

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