For now, there is a happy co-existence of the old and the new. The ECB’s announcement in May that it would purchase up to €60bn of covered bonds sent the moribund market into a catch-up frenzy. The primary market consequently witnessed the busiest session for new jumbo supply since May 2008.
Banks made a beeline to welcome the return of this important funding tool and promptly placed €6.5bn through five new benchmark bonds by the end of the week beginning May 11. It was an impressive revival, given that the first four months of this year only brought seven new benchmarks.
"It goes without saying that a powerful player like the ECB committing to absorb a significant amount of a certain market defines a hard valuation backstop," said Florian Hillenbrand, a covered bond strategist at UniCredit. "The fear of many investors, that every point of time for an investment was second-best because spreads widened with every new issue, is practically off the agenda."
Since mid-May, as supply in the covered bonds market has picked up, primary market activity in the government-guaranteed senior bonds space has cooled off. An increase in investor risk appetite has to some extent made market access possible across the credit and capital spectrum.
"The use of covered bonds as collateral for repo business with central banks has become more popular and economical, stimulating a major increase in the number of financial institutions issuing covered bonds," said Holger Horn, senior director in Fitch Ratings' covered bond team.
The €500m two-year priced by A2/BBB+/A- rated Alpha Bank on May 28th in the senior, unsecured, unguaranteed market, and the re-opening of the Lower Tier 2 bullet format (10-year trades from Rabobank and Credit Agricole) and callable structures (by insurers RSA and Prudential) and even the Tier 1 (courtesy of Rabobank, again) all demonstrate that the conducive market backdrop has been put to good use by financial borrowers.
There are significant fees associated with government-guaranteed bonds that do not generally apply to covered bonds, except in a few jurisdictions where the guarantees covered them. In the UK, for instance, bonds issued under the HM Treasury's Credit Guarantee Scheme attract a fee of 100% of the institution's median five-year CDS spread in the 12 month period to July 2008 plus 50bp per annum. Such fees have made covered bonds an attractive, long-term and cheaper source of funding.
"There is an overall allocation limit on the Credit Guarantee Scheme (£250bn), and the [UK] government does expect issuers to utilise other available sources of liquidity as well,” said Angela Clist, partner, international capital markets group at Allen & Overy. “Uptake under the proposed ECB scheme will be dependent on the applicable eligibility criteria."
Despite the gap between the cost of guaranteed and non-guaranteed issuance, in general, being about 100bp, banks have succeeded in issuing larger amounts with longer maturities without guarantee. This is an encouraging trend.
Not a one-trick pony
The glut of issuance in the two-and-three-year maturity space in the government-guaranteed senior funding market has convinced some market participants there could be pent up investor demand for five-year tenor or longer duration in the covered bond market.
Investors have recently shown a preference for relatively short-term risk of up to five years, which is maximum duration for the government-guaranteed market. But covered bonds have the advantage of the flexibility to extend out to longer maturities, which has some appeal to the real money investor base and to those investors looking to add some exposure to mortgage-market related credit risk.
However, the relatively low levels of public issuance of covered bonds makes it difficult to generalise. "The jumbo covered bond market has always been a five-year plus market, so no great change here," said Nick Morgan, managing director, head of financial institutions Europe & Middle East, RBC Capital Markets. "The GGB market simply replaced the senior unsecured market, which was always concentrated in two to five-year maturities to match the average life of most bank assets."
According to a FIG DCM banker, more senior, unsecured issuance is likely to be in maturities of up to five years as the government-guaranteed schemes start to wind down. On the other hand, the covered bonds market will see issuance ranging from three-year to 12 year maturities.
"The big question in this market is, as not everybody has access to everything, how will various issuers fulfil their different funding needs," he queried.
According to RBC's Morgan, "demand for duration is clearly there if the product [covered bond] is appropriately priced, which means a spread to senior unsecured debt. The last six months have been a sobering time for bank issuers, who are finally prepared to issue at levels that investors are prepared to buy at - largely because it is the cheapest alternative to paying for the guarantee and they have collateral available after 6-9 months of redemptions."
Supply picks up
As the GGB issuance market winds down, participants expect increased issuance of covered bonds in the next 12 months, as markets stabilise. In the more traditional covered bond markets such as France, Germany, Spain, Denmark and Norway, recovery is now apparent. Bankers expect other markets to follow in due course.
The ECB announcement is also likely to result in an increased in supply. However, uptake under the proposed ECB scheme will be dependent on the applicable eligibility criteria.
"Covered bonds ought to do well in the coming 12 months as risk appetite returns and banks seek to re-establish credit curves," said RBC's Morgan. "If GGBs are the ultimate in credit-enhanced senior bank debt, then covered bonds are the next step up the risk curve and can play an important part in the transition to orderly non-guaranteed bank debt markets."
In its EU banks’ funding structures and policies report in May, the ECB said government-guaranteed funding has been both too little and too much for the market: too little because it cannot cover all EU banks’ funding needs over the medium term; but too much because markets can only be deemed to have reopened when private investor confidence has returned in some form.
"The crisis has made it clear that liquidity has a cost, which should be adequately priced by financial institutions, both externally (funding liquidity: how easy the bank funds its position, and market liquidity: the ability to sell assets with immediacy at fair value) and internally (between business units of the same financial group)," the ECB said.
"Banks are keen to move away from issuing GGBs, just as soon as is practicable,” concluded Morgan. “Cost is clearly the key consideration, but there are other more political motivations too.
"In the medium term (next six months), GGBs will inevitably co-exist with senior unguaranteed issues - secured and unsecured - and I think the three can complement each other well. However, as we move into 2010, it's clear that the bigger, better banks will have successfully migrated away from needing the guarantee, leaving just the smaller and more troubled banks issuing GGBs. Covered bonds - with or without the ECB's help - should be able to flourish in this environment".