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IFR’s latest Covered Bond Roundtable, which took place in Frankfurt on May 29, assessed developments in the covered bond market from the perspective of bank funding in the context of a highly stressed Eurozone sovereign scenario. In the context of a negative feedback loop between banks and their sovereigns, it’s essential to understand what’s driving the relationship to understand what’s happening in the covered bond market in terms of sentiment, pricing and market activity.
Despite their undoubted attractions, covered bonds have been unable to circumvent the impacts of sovereign distress. Peripheral eurozone banks continue to be shut out of all capital markets; while the recent 3CIF issue sent French covered bond spreads spiralling out regardless of the quality of the underlying cover pools and temporarily closed the market to French issuers.
We have a classic split market in covered bonds that’s driven by psychology and negative headline risk. Notwithstanding the entry of credit investors, hedge funds and other new buy side participants into covered bonds, what this means is that the overall market is becoming far more domestically driven and parochial in the current cycle.
But that doesn’t take away from the fact that covered bonds will become a much more fundamentally important part of banks’ overall financing. The bank resolution debate, the outcomes of Basel III, CRD IV and other regulatory initiatives will alter the funding mix of Eurozone banks and will likely narrow the range of options banks have traditionally had at their disposal. In the evolving market environment, senior unsecured debt will no longer be the deep quasi-free funding class it has traditionally been. Bail-in will see to that. And wherever else you look, there are likely to be impediments.
Asset encumbrance continues to be one area of potential concern around covereds. Could this spoil the party? At present, it’s more a theoretical than actual. The bigger issue here is that because of increased regulatory scrutiny, the covered bond industry will have to work to justify the preferential treatment the instrument receives and lobby hard against regulatory moves to impose limits on what can be refinanced via covered funding.
Another area of concern is that covered bonds might be a victim of their own success. Put another way, will they survive the transition from specific funding instrument with narrow purpose to strategic funding tool with broad purpose refinancing a much bigger proportion of a bank’s balance sheet outside their traditional confines?
Big issues remain, but the “covered bonds are the new senior” mantra is more than just marketing hype from the industry’s army of aficionados; most market and regulatory developments play into the hands of the instrument. For many issuers, classic covered bonds are the only game in town if you think broadly about sourcing decent volumes of cost-effective debt issued into a network of well understood, well protected and secure regulatory frameworks. And for a market, that’s not a bad place to be.