Learning on the job
The measures employed by the European Central Bank to support both the covered and peripheral bond markets ultimately shared a common objective: providing aid to the ailing European banking sector. The outcome of the two programmes, on the other hand, has so far been mixed, as the performance of the underlying debt markets demonstrates. Michael Winfield reports.
The ECB’s response to the deterioration of the credit market differed from that of other central banks. The UK’s asset purchase programme can be seen as a response to a sharp decline in economic activity. The US response targeted the restoration of confidence in the housing market. The ECB’s priority was to support the European banking sector.
One of the immediate casualties of the financial crisis was a heightened credit differentiation. At times, the preservation of capital was seen as more important than the return on capital. The senior unsecured and covered bond markets fell from favour, as financial institutions became increasingly reliant on the support of their respective sovereigns. Starting with the offer of state guarantees at the height of the crisis, this soon resulted in the creation of a government guaranteed asset class in direct competition with other debt market participants.
“The increase in the debt burden of the sovereign sector, however, ultimately contributed to the sovereign debt crisis which became the next target of ECB policy,” said Emmanuel Smiecench, syndicate manager at SG CIB. “The ability to service much greater debt loads at a time of falling tax receipts, as economic activity declined, shifted investors attention to this sector, which since the inception of the euro had largely been viewed as a homogenous asset class.”
The explosion in peripheral sovereign spreads questioned whether all Eurozone members would still able to access the capital market. Ultimately, Greece lost market access and had to rely on an IMF and European Union rescue package in return for strict fiscal reforms. After this the spotlight quickly shifted to others that might suffer a similar fate, leading the ECB to undertake a similar asset purchase programme to support the peripheral bond market.
Covered intervention a success
The covered bond market, which was seen as a systemically important source for banks raising funds, had suffered a significant widening of spreads. In a number of countries the jumbo market was closed as a source of funding, although there were ongoing private placements and the closure of the market did not last as long as it did for some core markets. By early 2009 the market was dominated by occasional taps of existing deals by French, German and some Nordic issuers which were largely the only jurisdictions to brave new supply until the ECB announced a €60bn covered bond purchase programme in May that year.
“The announcement of the purchase programme in itself largely started to address the dysfunctional nature of the market although its operation did not commence until July 2009, with new issue volumes quickly recovering,” said Fritz Engelhard, head of covered bond strategy at Barclays Capital. “Along with the ECB’s LTRO, the covered bond market operation became an important part of the central bank’s strategy to ease credit concerns across the many jurisdictions which had previously functional markets. For the ECB covered bonds were clearly part of the solution, not part of the problem.”
In the week after the ECB announcement there was around €7bn of new supply (including two Spanish issues), more than there had been in the preceding five weeks. Although the level of supply subsequently eased, supply continued until year end and through into early 2010.
“Over the course of the year to June 2010 the ECB became a rather active participant in the primary and secondary bond markets which helped restore investor confidence ultimately leading to the market reopening for other more troubled jurisdictions, including the UK and the Scandinavian region which were excluded by the ECB,” Engelhard added.
The execution of the programme and the initial inability to borrow through the repo market from the ECB turned the market from being offered only to largely bid only. As financial fears eased, the ECB investors’ perception that spreads on covered bonds would continue to widen, and primary markets consequently grew in confidence.
Following the adoption of the common currency and the European convergence trade of the 1990s, peripheral spreads had traded in a narrow range. The general view held that there was very little difference in the credit of the eurozone members. Italy and Greece were perceived as the weakest members, although the spread between 10-year BTPs and Bunds rarely exceeded 30bp. After the financial crisis the spread increased and traded between plus 60bp and plus 80bp for most of 2009, before rising to plus 145bp in March, 2010 and peaking at plus 175bp in early June.
The driver of the peripheral meltdown that occurred soon after the New Year celebrations was a loss of confidence in Greece. This problem was exacerbated by an apparently successful five-year bond sale which widened by 40bp the day after it was priced. At the time the spread between 10-year Greece and Germany exceeded 400bp, with Greek bonds yielding more than twice as much as Bunds for the first time since early 2009.
Two rating agencies, Fitch and Standard & Poor’s, had downgraded the sovereign the previous month to BBB+, while Moody’s moved to A2 at the same time from A1 previously. Significantly, Moody’s remained the most important rating, as Greek paper remained eligible as ECB collateral if rated above Baa1 by Moody’s. In other words, Moody’s have would have had to downgrade the sovereign by two notches for Greek paper to lose its repo eligibility.
Subsequently, the debate shifted to whether the parlous state of Greek finances, after a 2.6% contraction in GDP in 2009, would receive support from the stronger European member states. Following a 10-year trade which initially maintained its launch spread, a seven-year issue in April proved to be Greece’s last public debt sale before the government was forced to request aid from a joint IMF/EU delegation that visited Athens later that month.
The spread on the new seven-year deal also came under pressure immediately after pricing despite 43% being sold to domestic investors (compared to 23% of the 10-year deal). In both cases the majority of the bonds placed with domestic financial institutions were used as repo eligible collateral. The ECB was forced to ease its criteria in July to ensure financial institutions could secure financing at favourable rates, thereby assisting the process of financial and economic recovery. Although Moody’s now rates Greece at Ba1, the ECB still accepts Greek government debt as eligible collateral with the additional 5% haircut for government bonds rated below A minus.
Although Greece was effectively removed as the source of the instability in peripheral markets, the spotlight soon shifted to other countries which might also be in danger of suffering a similar fate. The spreads of Spain, Ireland and Portugal in particular soon started to rise. The ECB eventually responded by intervening to purchase the debt of Ireland, Portugal and Greece, although the latter had already been downgraded to junk status.
“Because the size of the sovereign debt market is much larger than the covered bond market, making the ECB’s objective more difficult to achieve, it was important to address the Greek situation (through market intervention) as this was the focal point of the recent sovereign spread divergence,”said Nathaniel Timbrell-Whittle co-head of SSA DCM at BNP Paribas.
A nominal amount of €16.5bn was acquired in the first week the ECB intervened in May. In the weeks that followed the purchases fell initially to €10bn and were €4bn per week by early July, averaging around €150m per week in the eight weeks to early September. The rapid decline in the amount of assets being purchased, while not irreversible, is largely seen to be directly correlated to the subsequent widening of peripheral spreads with Spain, Ireland, Portugal and, to a lesser extent, Italy all remaining vulnerable.
The weakness in peripheral markets continues to impact covered bond supply: “The fact that covered bond issuance levels have been under pressure in many jurisdictions was largely a function of the dislocation of the spreads of the underlying sovereigns, rather than being related to a perceived failure of the ECB’s covered bond purchase operation,” said Barcap’s Engelhard.
“The operation of the peripheral programme has, unlike with covered bonds, been applied on a much more variable basis and consequently the results are- at this stage- more mixed,” added Timbrell-Whittle at BNP Paribas.“In part this is because the purchase programme is only part of the ECB strategy to address the spread divergence that has occurred with the creation of EFSF effectively a means of insuring member states’ access to funding.”