Sunday, 19 August 2018

Running for cover

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The European Central Bank’s covered bond buying programme draws to a close at the end of June. With a massive Eurozone bailout underway, support remains for the asset class, which is predicted to thrive. The programme has probably been a success by most measures, yet come in for criticism from various quarters. David Rothnie reports.  

Opinion is divided over whether the €60bn covered bond scheme launched last May by the European Central Bank has achieved its aim. One thing bankers do agree on, though, is that the asset class will not want for support when the programme expires at the end of June.

“All roads lead to covered bonds,” said Ted Lord, head of European covered bonds at Barclays Capital. “In this new era of volatility for the sovereign bond market, people are seeing even more clearly the ultra-safe quality of the covered bond. If the bank gets into difficulty, you can separate the assets. Throughout history, we have had several cases of government defaults while simultaneously the covered bond was paid on time and in full.”

The ECB is on course to meet its target of €60bn at the end of the month. Further support for the asset class is also in prospect, via the €750bn rescue package launched last month by the ECB and the International Monetary Fund. “The wording of the Asset Market Purchases is suitably broad to allow the ECB to continue buying covered bonds,” said Lord.

“At the moment, no-one is really concerned about the end of the ECB buying programme because of broader market trends and the fact that the ECB might in any case have to continue with unconventional monetary policy measures for quite some time,” said Bernd Volk, head of European covered bond research at Deutsche Bank.

This, combined with market volatility putting the brakes on supply, may have been factors behind the absence of a last-minute rush to issue paper in anticipation of the scheme closing.  However, the ECB has also been careful to roll out its covered bonds purchase programme in a gradual and orderly manner. As of May 31, official data showed the ECB and the Eurozone’s 16 national central banks had bought €54.7bn of covered bonds.

Starting with a bang

The covered bond market started the year brightly. There was €45bn of issuance in January alone, as French banks Cie de Financement Foncier and Credit Agricole, and BBVA of Spain, all tapped the markets with jumbo issues of €2.8bn – the largest deals to date.

Issuance dropped to €18bn in February, before rebounding to €42bn in March. Since then, issuance has slumped as the sovereign crisis escalated, choking the market to only €4bn in May: the market was shut until Deutsche Hypo issued a 5-year mortgage Pfandbrief  issued at mid swap +10bp, for €600m on May 17. Around that time UniCredit sold a 7-year mortgage Pfandbrief (€500m) at mid swap +15bp.

The sell-off meant that the ECB programme fulfilled its role as providing backstop funding for the market as covered bonds shadowed the sovereign market.

Covered bonds were already used as collateral for repo operations with European central banks. Central banks often invest in covered bonds for the placement of their equity. However, according to a report from Fitch, the announcement by the Governing Council of the ECB in May 2009 of an outright purchase of covered bonds fulfilled a different purpose: “Its aim was to contribute to a reduction in funding costs for credit institutions, to improve liquidity in the secondary markets and to promote the continued access of private individuals as well as companies to funding.”

When the scheme was first announced, there were concerns that it would backfire. It followed months of reduced issuance in the primary market. “The immediate reaction from the market to the ECB programme, before the details emerged, was to go from offered-only to bid-only so illiquidity moved from one side of the market to another,” said Mauricio Noe, head of head of senior and covered bonds at Deutsche Bank.

However, the programme boosted the confidence of all market participants. According to Fitch, it removed a source of uncertainty for those covered bond investors previously hurt by spread widening. Primary market issuance resumed, although as the scheme progressed the ECB said more than two-thirds has been bought on the secondary rather than the primary market. In order to address the risk that his buy-and-hold strategy might hamper the same liquidity the scheme was intended to stimulate, the ECB Governing Council decided in March 2010 that the purchased bonds could be made available for lending to eligible counterparties through re-purchase agreements.

Being perceived as low risk, covered bonds have become an even more crucial source of funding for Europe’s banks following the financial crisis. The fact that banks hold the collateral in the form of real estate loans on their balance sheets, giving lenders resource to the assets in the event of a default, made them a secure antidote to the sort of complex structured products – often based on no underlying ownership – that characterised some bank funding in the past.

“The covered bond market is a essentially a sovereign surrogate market with an element of state sponsorship through the covered bond laws, although few would disagree it is less liquid. In this sense it was a form of mild quantitative easing and provided a ceiling for the sovereign bond market by keeping a lid on spreads,” said Noe. “This is largely because conventional wisdom used to be that covered bonds always trade wider than their domestic sovereign.”

Their safety also made them politically popular, setting an example for other markets to follow in tougher regulatory times. But the programme has not been without its critics. Some have asked why such support was provided to an asset class that did not need protecting in the first place. “The ECB programme has been a success because the covered bond market is the only fixed income market that is bigger now that it was before the credit crisis,” said Lord.

Other critics of the programme, coming at it from another angle, said it was of insufficient size. Over the past decade, covered bonds have become one of the largest asset classes in the European bond market: outstanding covered bond issues (both public and private) have increased from less than €100bn in the mid-1990s to around €2.4 trillion in 2009. 

However, Lord dismissed such criticisms: “The €60bn is a significant proportion of the public covered bond market, which is much smaller than the total size,” he said.

Helping those who need it least

Many argue the programme was undermined by national interest. According to Fitch, the total amount of the €60bn programme was allocated between the ECB itself (8%) and the national banks of the euro area in proportion of their participation in the ECB’s paid-up capital.  Fitch cites the top four as Deutsche Bundesbank with 25% of the programme, Banque de France with 18.7%, Banca d’Italia with 16.5% and Banco de Espana (10.9%). 

“But the difficulty lay in the mechanism that the ECB deployed in choosing the national central banks to do the buying,” said Noe. “This meant national interest came to the fore as central banks tended mostly to buy their domestic bonds.” In a leading indicator of the broader Eurozone crisis, the support was therefore not directed at those banks which needed it most.

In a note to investors last month, Volk said: “The peripheral covered bond market is back to pre-ECB buying, probably worse. Short of distressed buyers willing to buy covered bonds trading below 80 in price, if any, there seems no bid. While there seem numerous buying opportunities given the collateral protection and support for covered bonds, we struggle to see a turnaround without unconventional measures by the ECB or other aggressive policy measures. Lack of covered bond access is a broader and serious topic for peripheral bank funding.”

The flight from peripherals is a big challenge for the covered bond market. The recent turmoil will keep it high on the agenda. Without the ECB programme, banks in peripheral covered bond markets may have struggled to fund themselves. “There was a pressing need to get the peripheral market going,” said Lord. “Central banks initially favoured their own country’s covered bonds as they had established credit lines with these local names. After they were able to do the credit work and learn more about other covered bond markets, the purchases by the Eurozone central banks became more Europe-wide. One of the big advantages of the Covered Bond Purchase Programme is that it gave banks the ability to finance themselves in the longer tenors and exit the shorter-term government guarantee programmes.”

Last month, the ECB said it would extend the government guarantee scheme, delivering a potential blow to the covered bond market. “They have made it clear they have massively increased the fees associated with tapping government-guaranteed debt so banks only do it as a last resort,” said Noe. “You’d still issue covered bonds because they are cheaper and it’s better to be in the market.”

But it is too early to judge whether the programme has met its objective to channel funding into the private sector, said analysts, rather than giving banks an opportunity to hoard liquidity.

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