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Wednesday, 01 October 2014

ECB to the rescue

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The impact of the ECB's unconventional covered bond purchase programme has been nothing short of extraordinary. Market spreads, and hence funding costs, have fallen dramatically, and the amount available to banks has risen sharply. But this has created a number of worries, such as whether the market can sustain the resultant influx of supply, whether another bubble is being inflated, and how the market will react to an ECB withdrawal. Rachelle Horn reports.

Before the European Central Bank even spent a penny of its proposed €60bn covered bond purchase programme, the announcement in May that it would prop-up Europe's €2trn covered bond market was enough to put the asset class on the fast-track to recovery.

The ECB had essentially set three goals: a tightening of spreads, the resumption of issuing activity in the primary market and a revival of activity in the secondary market.

Two months after buying commenced, covered bond spreads had tightened 60bp on average. So profound was the effect, it "probably had the most significant impact of all the crisis-fighting measures taken by the ECB," according to Florian Hillenbrand, a covered bond analyst at UniCredit. It "brought immediate relief for market participants,” he added.

Having ground to a complete standstill following the collapse of Lehman Brothers, September yielded its second busiest month since its 1995 inception for jumbo issuance. At about €28bn, new covered bond issuance far exceeded the supply from the first four months of this year, when investor demand only facilitated €15bn of new deals (see chart).

Even the secondary market has seen some revival in activity, though according to Ralf Grossman, head of covered bond origination at SG CIB, it remains below the level it was at before the crisis. "The banks are now focusing much more on client service and less on interbank activity."

The goal of reviving activity in the secondary market clearly has further to go. But it has at least moved away from the seller only market it had become before the announcement. More two-way flows are being reported.

According to Andrew Porter, global head of covered bonds at HSBC, "as Pfandbrief spreads moved down below the mid-swaps plus 20bp level, we began to see a much greater willingness of investors to take profit on holdings causing bid/offer spreads to narrow quite sharply."

The increased appetite for covered bonds among investors, particularly from those looking for a pick-up in spreads, has facilitated issuance from a number of jurisdictions that had barely been visible since the collapse of Lehman Brothers. At least for the time being, the covered bond market appears open to all jurisdictions that prior to the ECB announcement would have found it difficult to place a jumbo deal – even those that suffered the most in terms of market spreads and underlying housing sector concerns, such as Ireland and Spain.

Beyond the Eurozone

The improving sentiment in this market from the purchase of bonds within the Eurozone has also facilitated the issuance of new covered bonds outside this region. After a two-year absence, the UK was the last European jurisdiction to finally return to covered bonds, with Barclays Bank – a debut issuer in the jumbo asset class – completing the jigsaw with a €2bn 4% 10-year deal.

But not only has the marketability for covered bond issues outside the Eurozone improved, the cost has also lessened. Take Stadshypotek's €1.5bn 3% October 2014 at mid-swaps plus 35bp: Swedish covered bonds are not included in the ECB buying programme, yet the deal was well supported in the market, with investor orders totalling €3.4bn.

According to Porter, the deal – joint-led by HSBC – would have had to pay a mid-swap spread in the high double digits before the purchase plan. Despite being excluded from the scheme, the issuer still achieved a spread of plus 35bp as a result of the overall tightening in this market.

"I would currently put the differential that non-Eurozone issuers are being asked to pay at around 10bp," said Porter. "We will see that premium reducing as the market appreciates the strength of demand from central banks and official institutions buying covered bonds outside the purchase plan."

With talk of investor fatigue where the tighter-trading jurisdictions are concerned, the majority of supply continues to come away from the so-called "core" France and Germany, the latter seeing some of its covered bonds trade as tight as mid-swaps flat.

The Elephant in the room

With issuers now finding their financing costs in covered bonds increasingly competitive, the speed at which the issuance has returned is difficult to ignore. These banks are now able to refinance at much tighter levels, and the marketability of a jumbo deal has improved significantly. On the other hand, according to analysts at BayernLB, banks are also under significant refinancing pressure due to about €250bn of jumbo bonds coming up for redemption this year and next.

For the time being, a negative impact is not visible. But Sebastian Sachs, a covered bond analyst at DZ Bank, said the involvement of the ECB, and the positive sentiment created by the resulting swap spread tightening, is distorting the market's development – at least as far as the primary market is concerned.

"We believe this is the source of big danger, namely that a bubble is growing in the covered bonds primary market right now whose bursting could bring all the recent progress to a standstill again," he said.

Michiel de Bruin, head of Euro government bonds at F&C Amsterdam, believes that talk of a bursting bubble is premature. "One could say that covered bonds were undervalued and I think spreads are now simply moving back in the direction of where a Triple A rated product based on European prime mortgages ought to trade. In that sense, it is not a big surprise that spreads have tightened. What is surprising is the sheer extent of the tightening in such a short timeframe," he said.

"We have been positive on valuations in this asset class this year. There is a big difference between covered bond jurisdictions and it is important to look from a bottom-up investment approach with regards to collateral pool and spread level."

De Bruin said there is room for performance from Spanish and the UK covered bonds. "We have already seen a contraction of spreads in the respective government markets," he said.

But there is still a mountain of liquidity waiting on the sidelines that is only too happy to absorb this massive wave of issues, said DZ's Sachs. "Every name that starts bookbuilding at short notice is finding their stock flying off the shelves," he said. "The promise of further spread tightening is fuelling demand. Moreover, investors still have problems finding attractive material [whether in big or small lots] in the secondary market."

While Sachs maintains that positive sentiment will continue to buoy up the primary market in the weeks to come, he admitted to being afraid “that the flood of new covered bonds [especially from jurisdictions that have not shared much of the earlier action] will not slow in the foreseeable future, and the time will eventually come when the market will no longer be able to absorb the new paper without problems, or no longer at the same ultra-tight issue spreads. That is when we will see just how stable the recent trend is – especially the surging secondary market."

Aside from the ballooning supply, the other elephant in the room that all investors are keeping a watchful eye on is the ECB's exit strategy when it ceases to buy covered bonds in June next year.

"We are still in the honeymoon period where this is concerned, but ultimately, people will have to prepare for the fact that that the average daily buying of around €250m in the primary and secondary market as part of the programme will come to an end in June," said Grossman.

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