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Friday, 15 December 2017

ECB still too good to pass up

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Having been intermittently locked out of the covered bond market for 2012, peripheral banks in Italy, Spain, Portugal and Ireland now have full access and can often fund through their government curve. While this seems to signal that they are on their way to regaining a firm footing in the capital markets, the cheapness of ECB funding is still proving a very attractive alternative.

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Peripheral banks were expected to forge a comeback to the debt capital markets this year, but apart from a few showcase covered and senior bond deals many treasurers seem unconvinced, saying spreads are too high and that cheap European Central Bank funding is just too good to turn down.

“The issue now is that spread levels are still too high, and that we expect them to fall further,” said Isabel Almeida, director general, department of finance and markets at Banco Espirito Santo speaking to IFR in May, just after the Portuguese sovereign sold a €3bn 10-year syndicated bond.

“The success of the sovereign is certainly encouraging, but does not come as a surprise to us considering the feedback we are getting from investors and the number of reverse inquiries we are receiving”

“The success of the sovereign is certainly encouraging, but does not come as a surprise to us considering the feedback we are getting from investors and the number of reverse inquiries we are receiving.”

As it stands, issuers like BES, Bank of Ireland, BBVA and Intesa can borrow from the ECB at 0.5%, but these banks regularly have to pay as much as six times that amount in a public bond deals despite an improvement in funding conditions for peripheral borrowers in large part due to the provision of cheap loans by the central bank.

The ECB’s three-year LTROs, which ploughed some €1trn into the market, were aimed at warding off a liquidity crunch in the banking sector, but they were not supposed to be a perpetual crutch for Europe’s troubled lenders.

Syndicate and DCM officials alike argue that, sooner or later, banks in the eurozone will have to stand on their own feet and seize funding opportunities when they are available.

Indeed, the month of June served as a good reminder that windows are not permanently open, and that funding through the cycle remains most prudent.

“Both issuers and investors will benefit if there is an ordered and steady stream of issuance, rather than feast and famine where levels need re-validating, liquidity dries up, and markets need frequent ‘re-opening’ transactions,” said a London-based FIG banker.

Heading for cover

Certainly some banks in peripheral countries are starting to make an effort to wean themselves off cheap ECB funding.

Spain’s banks began paying back ECB funding earlier this year and have been making a concerted effort to reduce their funding through the ECB. The countries banks borrowed €259.3bn from the ECB in May, down from €265.1bn in April, marking the ninth consecutive month of falls.

A retreat from ECB funding means that banks are likely to first turn to the relative safety of covered bonds.

“In Spain we have seen Tier 2 and Tier 3 banks coming to the market so we think it’s only a matter of time before we start to see the national champions back again,” said Torsten Elling co-head of rates syndicate at Barclays in London.

“A combination of low issuance volumes and high redemptions are going drive in spreads further, which means lower funding costs for European banks.”

But in Ireland and Portugal the situation is not so rosy and ECB cash is proving all too attractive. Irish banks’ borrowing from the ECB and their own central bank inched up in June, which served as a reminder of the challenges still facing the sector.

Ireland’s banks, at the root of the country’s financial crisis, are reliant on central bank loans to fund their day-to-day operations due to tens of billions of euros in deposit outflows and their exclusion from interbank lending markets.

Despite this unfortunate situation, a number have been keen to show they have access to the covered bond market. Bank of Ireland, 15% state-owned and the only Irish bank to avoid wholesale nationalisation, was the country’s first bank to return to the public market, issuing a €1bn covered bond in November 2012 that was quickly followed up by compatriot AIB.

It then went a step further in 2013 and braved the senior unsecured sector to price a three-year deal on the back of a €2.5bn book that offered a pick-up of around 100bp over government bonds.

But the deal widened dramatically in the secondary market and certain market observers though the senior deal may have been a step too far as at one stage was quoted more than 100bp back of its mid-swaps plus 220bp pricing point.

“Senior deals that have been issued recently need to perform and get back to the levels that they priced at before other banks are going to follow suit,” said Elling.

“Peripheral banks have a lot of funding needs and covered bonds have been providing a stable avenue for them to borrow cash from investors throughout the crisis.”

Regulators are encouraging banks to make a full return to the public market and due to the volatility of senior unsecured deals relative to covered bonds, bankers say covered bonds are the obvious funding tool.

“We would like to see a mix of covered and senior unsecured issuance for the coming year,” said Ralf Grossmann, head of covered bond origination at Societe Generale.

“Issuing senior unsecured bonds is a great achievement for a peripheral bank but covered bonds are regularly managing to price through their sovereign so they offer a pricing advantage. It makes sense for covered bonds to price through sovereign debt because they are a bit more predictable in terms of their secondary performance.”

For many issuers a combination of ECB and covered bond issuance will be the obvious means of handling this renewed bout of volatility that is expected to continue for the near term.

Talk of tapering off of the US’s popular QE shut the senior market for the month of June which led issuers back to the comfort of covered bonds. During that month, low beta banks favoured secured bank funding, pricing €7bn through 12 deals – but only one was a peripheral lender.

“Talk of tapering off QE and the impact it will have on rates will only temporarily spoil the covered bond party,” said Grossmann.

“Like before, the market will resist pretty well in more volatile times.”

Game of two halves

Second-tier Italian names, another wave of Spanish issuers, Irish banks and Portuguese credits are all expected to make an appearance in the second half of the year but are unlikely to break away cleanly from the cheap funding offered through the ECB.

“Supply is likely to remain moderate because a lot of banks have reached their limit in terms of the collateral they have available and in lots of cases the yield they are paying is higher than the money they are making from the mortgage business,” said Grossmann.

But it’s more than price that will lead banks into the safety of covered bonds over senior unsecured debt.

“It will be easier for banks in peripheral countries to sell covered bonds as they are typically rated investment grade, whereas some of the senior ratings won’t make the investment grade cut which will make issuance more challenging,” said Grossmann.

For the second half of the year, bankers expect a steady flow of covered bonds where non-eurozone supply is likely to be the only region of Europe to see some positive supply dynamics as issuers need to lengthen the duration of their liabilities.

Other troubled jurisdictions may also to turn to the product to benefit from its safe-haven status.

“The covered bond market is developing into its own universe where emerging market players are now looking to use the product. We expect to see more developments this year and banks to continue to turn to the product in times of stress,” said Elling.

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