IFR Covered Bonds Roundtable 2017: Part 2

IFR: We have touched on pricing dynamics but it would be good to go into a bit more detail. You seem to agree we are unlikely to get back to levels we saw early last year, but is pricing attractive at current levels? And how do different regions compare? Is Germany still relatively keenly priced?

Bodo Winkler, Berlin Hyp: Since the ECB programme has been in place the pricing from different jurisdictions converged continuously. German Pfandbriefe had the worst performance of all because they already had the tightest spreads before and then the others converged to that.

That is why, when the programme comes to an end, I expect to see the products that potentially suffer most will be the ones that benefited most from the programme. At the moment there is no real differentiation between the products by prices or spreads, but in a normal environment you should see larger differences between different jurisdictions.

Jens Tolckmitt, vdp: We say the same thing to investors. Since the “Draghi Unlimited” speech there has been a consistent narrowing of spreads across basically all markets. The ECB action must be driving that because the fundamental factors have not really changed.

Once this support is removed it seems highly likely that the markets that have tightened most will be the ones that lose out most. The German market has been characterised by its low volatility throughout the crisis, regardless of external shocks, and while you would not call the ECB action a shock it is certainly an external event, something separate to the factors that normally drive the market.

Ted Packmohr, Commerzbank: If we’re comparing spreads we have to differentiate between the third covered bond purchase programme (CBPP3) and the non-CBPP3 countries. People tend to be more open to exposure to Canada, for example, because it is a non-CBPP3 country and there might be better relative value there. The market is not so mispriced.

After the widening we saw towards the end of last year there is also a market spread differential in the peripherals, namely Spain and Italy, where there has also been limited supply. I would think people ought to be quite open to Spanish covered bonds these days while the story is different in Italy, as there are other fundamental factors in play. But we’ve only seen one benchmark deal from Spain so far this year, which was CaixaBank, which I believe was a very successful deal. It was seen as offering an attractive spread, which says a lot about where people are willing to put their money.

As for ECB tapering, that is already a fact in our market. Other segments are still speculating about what might happen but the ECB is already tapering its covered bond purchases and has been for quite some time. It has significantly and strategically reduced its presence in the secondary market due to liquidity bottlenecks.

Bodo Winkler, Berlin Hyp: There’s nothing to buy any more.

Ted Packmohr, Commerzbank: But they could try to force it. In December, for example, there was a clear lack of bids in the market and it was because the ECB has backed away from being the buyer of last resort. You can no longer assume the ECB will be there no matter what, even in times of stress.

I agree that part of this is down to a lack of paper for them to buy. But they are also not pushing it to the limits, otherwise spreads would be at even tighter levels. So this tapering is already happening in the covered bond market.

It does not have to materially affect spreads as long as they remain sufficiently active, at the edge of market capacity. It’s less about the amount they are buying, it’s the additional volume that would be available if they were not active, and how much of that they are soaking up. Even if they scaled down their purchases even further, the fact they are still in the market at all might be enough to keep spreads relatively tight. It looks like they are winding down the programme very slowly.

Ralf Grossmann, SG: I see your point but I do not fully agree with it. The ECB has already indicated it wants to get from €80bn purchases down to €60bn from April onwards.

What we have seen so far is the ECB pulling out of the secondary market because there wasn’t enough paper to buy. Supply just dried out and they couldn’t find the bonds. And then even in the periods where there was enough in the secondary market for them to buy, they didn’t.

But it is still alive and kicking in the primary market. And while the allocation obviously depends on the overall demand, that is determined by investor expectations. So I think we will feel it in the primary market when it tapers its purchases there.

And when it stops buying other types of paper we will feel that in the covered bonds market as well. That is a real concern, because how will that work? It’s like open heart surgery, it will not be easy.

Ted Packmohr, Commerzbank: I think there will be a real feedback loop once the ECB announces official tapering. It will impact the government segment, which means the whole market will feel it. Still, we might not have a similarly huge problem in the covered bond segment because the central bank is already buying less covered bonds per se and should withdraw from the market very cautiously. Our economists think there is a high chance the ECB will provide some other measures to compensate for its withdrawal from the asset purchasing programme, however, such as a new round of targeted long-term refinancing operations (TLTRO).

Jens Tolckmitt, vdp: That’s what I meant. That might hamper estimated issuance in the Pfandbrief market going forward in 2017.

Ted Packmohr, Commerzbank: Exactly. Of course that will put a dampener on new issuance, but it will also keep spreads from widening too drastically.

Ralf Grossmann, SG: That would clearly be a form of back-door market manipulation.

Bodo Winkler, Berlin Hyp: It was market manipulation all along.

Ralf Grossmann, SG: It’s more market manipulation then, through the back door. It is telling the market it has stopped its activities and things will go back to normal, but then reducing volumes with a TLTRO.

We share this concern, that the ECB will come up with another programme. It really just shows how difficult it is to remove this kind of support.

Jens Tolckmitt, vdp: But until the ECB formally announces it is tapering, or exiting the market, I expect market participants will continue to factor in its involvement, which means spread movements might not be that substantial.

If you look back at the first purchasing programme, it had an overall volume of €60bn. Considering the size of the market it was operating in, that was basically a small-scale instrument. But it achieved what it wanted to achieve, spreads moved in – it was enough to know that the ECB would be there if it was needed.

The current situation is similar. If it says it will start to reduce its purchases the market will still feel supported. If Draghi went further and said “We will not do whatever it takes”, if he said he would not support the market, you would see an impact. But while the market feels it is being closely watched by the ECB there is no problem. Finally, any widening would likely be relatively limited in the Pfandbrief market compared with other covered bond markets.

Ralf Grossmann, SG: The best scenario we can hope for is that the ECB stays close to the market, that it does not explicitly remove its unlimited commitment and therefore leaves open the possibility it will come back. This is what it did with CBPP1 and CBPP2. It means it can step back in if the market gets out of control. I do not expect the market to spin out of control because the ECB reduces its purchases, I hope for a good transition. I think there could be some jitters but not the kind of explosion we saw during the financial crisis.

IFR: But what kind of impact is it going to have on the primary market? There have been deals where the ECB has bought, perhaps not as much as 50% but certainly a huge chunk of a transaction. So surely if the ECB is no longer there that has to have an impact on spread? The ECB is essentially a huge anchor investor that will not be there any more.

Bodo Winkler, Berlin Hyp: Of course this will have some sort of effect. We have always been clear, even before the programme started, that we prefer real investors to one that is only there for a limited time and due to a programme in the market – and that of course was reflected in allocation. It is important for us, that we could have done every deal since the ECB entered the market without its help.

We were always concerned that its presence could force real investors out of the market. That was when Berlin Hyp decided to invest its efforts into building up a green franchise. That has been very successful and has brought us new investors. We extended this then to senior unsecured, where the investor diversification effect was even bigger.

We believe that this will help us in the kind of environment you are talking about.

Juergen Klebe, Deutsche Hypo: If you have a situation where half a transaction is absorbed by a single investor, that’s a problem. We have maintained our commitment to attracting investors by speaking to them, making sure we have our traditional investors on board. But on the other hand, banks will have to accept that their syndicates will have to work a little bit harder again.

Creating something special, such as a new product like the green product we were just hearing about, is a good strategy. Those kinds of investors, which are green right down to their genes, which might even have greenness in their name, tend to be a new kind of investor. Then you are not relying on banks to take 70% or 80% of your paper with a single investor buying the rest. It’s a little bit more work for the issuer and for the bank syndicates, but it is worth it.

But ultimately I believe there will always be investors interested in high-quality products like Pfandbriefe.

IFR: Were talked earlier about how the private placement market has dried up. As a result issuers are having to rely more on the public markets and maybe the ECB has helped with that. Do we go back to private placement or do you feel the benchmark market is established enough now and insurance companies might come back in once yields rise more?

Juergen Klebe, Deutsche Hypo: I would say it’s a mixed picture. So as far as the long end of the Pfandbrief is concerned, there will always be insurance companies active. Their activity has declined a little bit because of the absolute yield but they are still active.

I don’t see a comeback for private placements in Pfandbriefe due to the LCR. With roughly 70% of the investors in this product being banks, that is unlikely to change. So it will continue to be a benchmark world.

It is a different situation for the senior unsecured market. There you’ll see a very granular private placement market that still works. But for Pfandbriefe it will be all about benchmarks.

Martin Lenhard, Moody’s: I think higher rates and higher spreads might reverse the trend that we’ve seen. We could see the market return to a situation with more investors besides central banks and bank treasuries, which currently dominate the market.

IFR: What’s your view on tapering and ECB?

Martin Lenhard, Moody’s: From a rating agency point of view it introduces some uncertainty about the liquidity in the market and the refinancing of issuers. My personal expectation is that interest rates will go up and spreads might widen, especially for weaker issuers and countries. But it will be a much healthier market.

IFR: You wouldn’t anticipate taking rating actions based on that, because spreads are more elevated for issuers?

Martin Lenhard, Moody’s: No, we expect to see spreads widening but not to the extent seen at the height of the financial crisis.

IFR: One thing you mentioned was the pattern of issuance. We have not seen the banks from the periphery, why have they been so absent so far this year?

Ted Packmohr, Commerzbank: There are several reasons for that. In Italy in particular there are obviously some structural issues at play. Monte dei Paschi di Siena has been the focus but also other banks are going through some restructuring and capital raising exercises, which is keeping them busy.

Some of these banks rely relatively heavily on retained covered bonds. So in fact there has been issuance from peripheral banks, we have seen some pretty impressive numbers being printed by the peripheral institutions – as well as by a very prominent German bank – which are launched as retained bonds. They are rarely officially marked as retained, obviously, but what else can you do with one block of up to €8.5bn?

Various peripheral issuers have made very active use of this niche, and it seems quite possible this might have played a role in TLTRO funding. That’s why I said if the ECB does return with another TLTRO exercise, it could provide an attractive alternative, particularly for peripherals but also for some core issuers.

IFR: That could definitely undermine issuance. To what extent will German banks make use of the TLTRO?

Bodo Winkler, Berlin Hyp: I cannot speak for German banks, I only can speak for Berlin Hyp. For us this would come only in addition to our normal funding mix. It offers an alternative maturity, which is very interesting for us at a potentially interesting price. If it makes sense from an economic point of view banks should look at it.

Ted Packmohr, Commerzbank: I think there’s another factor that we haven’t touched upon yet ,which is the regulatory funding that many banks have to do. The whole non-preferred senior segment is really coming to life in France and Spain, which banks need for regulatory purposes but means they have less need for covered bond funding. That is also going to have an impact on new volumes.

Bodo Winkler, Berlin Hyp: The situation in Germany is different. Many banks have issued senior unsecured, which is non-preferred, and being non-preferred means being MREL-eligible. That means future issuance would be rather to generate funding than to fulfill ratios.

Ralf Grossmann, SG: The question is, what happens if there is some kind of harmonisation of legislative frameworks? How would that change things?

Bodo Winkler, Berlin Hyp: It would be hard for authorities to turn around and say the decision that had been made in 2015 was wrong and now things are going to be the opposite of what they were.

IFR: They might not have a choice if it comes down from the EU level.

Bodo Winkler, Berlin Hyp: The EU Commission’s proposal in November was to have two different senior unsecured asset classes. I understand that there was no requirement on how to deal with existing senior unsecured notes. France chose to deal with it in one way and Germany already in 2015 chose another solution. What we don’t have at the moment is a preferred instrument.

Martin Lenhard, Moody’s: I would be surprised if we saw harmonisation in the covered bond market while at the same time we moved to a less harmonised senior unsecured market.

Bodo Winkler, Berlin Hyp: I fully agree but a trend towards harmonisation does not necessarily mean everyone has to take the same route to get to that state of harmonisation. If the result is the same – two asset classes instead of one, a preferred and a non-preferred – that would still mean harmonisation.

Ralf Grossmann, SG: It’s a tricky question because the EU Commission’s paper was also targeting a level playing field, and one element of that is surely how much non-preferred senior issuance we need. In a country like Germany issuance is already predominantly non-preferred. It’s maybe not what the EU Commission understands as a level playing field.

Of course Germany could easily introduce a preferred senior instrument. I’m not a lawmaker but that should be doable. The question then is about grandfathering. We will see answers to these questions in the coming months and it is not clear what the outcome will be.

Bodo Winkler, Berlin Hyp: This is one of the most interesting questions we face this year.

Ralf Grossmann, SG: Yes it is, and it obviously has implications for the covered bond market and how much issuance we will see from different countries.

And on the TLTRO side too, it’s not only German issuers that are using this, it offers a preferred rate that is unbeatable. Even a 10-year issue is not going to offer a comparable rate, so issuers are more likely to go with a four-year deal and wait to see what happens. It is a really strong instrument in many countries and it means there will be a cap on covered bond issuance.

IFR: I thought the TLTRO in March might be the last one but if the ECB is tapering it will be interesting to see what it does. We can’t go on providing the banks with ultra-cheap liquidity forever. At some point they have to stand on their own two feet, they haven’t done that for a long time.

Ted Packmohr, Commerzbank: I wouldn’t say that the banks are incapable of standing on their own two feet. But the ECB might be keen to send out the signal that it wants to keep up the monetary impulse, despite having run into the limits of what it can do with the asset purchase programme. It might be looking for some alternatives, combining tapering with other measures to keep liquidity flowing.

Juergen Klebe, Deutsche Hypo: It’s just an offer, banks don’t have to take it. They will take it if they want to open a new maturity or for some other reason, but they are not forced to do it. Those with good funding access in the Pfandbrief or the senior can use those markets, if they are not sure about growth they will not take the TLTRO because then the levels are quite different.

IFR: Let’s get back to the senior market and how issuers balance their covered bond funding with senior funding. There might be some uncertainty in terms of what counts and what doesn’t, in terms of this uncertainty around harmonisation. There are also questions around some of the features that German debt includes, and whether the European Commission wants those features to be allowed. What do you think about total loss-absorbing capacity (TLAC) and MREL?

Bodo Winkler, Berlin Hyp: As a German issuer we have to deal with what is provided by German insolvency regulation. That means we have one senior unsecured asset class at the moment and that is non-preferred. Of course there are structured notes too but for a bank like ours these are not there to generate large funding volumes as we could not introduce the required features to a benchmark deal.

In our case senior unsecured bonds are used to generate funding for assets that are not covered bond-eligible. That is why I say we use senior unsecured purely to generate liquidity. At the moment when we think about MREL we would have to calculate the ratio in the way set out by the legislation, which means taking existing senior unsecured issuance into account.

Juergen Klebe, Deutsche Hypo: It is the same for us. This so-called ‘senior senior’ is pretty meaningless for us, we are talking about one or two issues with practically zero volume. All our senior issuance is non-preferred.