It has been a long, cold winter in the financial markets. The land of the covered bond has been as bleak as anywhere, with issuance in 2008 and early 2009 reducing to the merest of trickles. In 2008 there were questions about whether the covered bond market could ever regain its relevance after the emergence of the government guaranteed market robbed it of its natural investor base.
But now some are latching on to evidence that spring might at last be here – at least in this corner of the financial markets. May saw a rebound in the fortunes of covered bonds: more was raised via the instrument in one month than in rest of the year combined. But is this evidence of a changing of the seasons, or merely a winter heat-wave?
If there is a single phenomenon shining light and warmth on the industry and causing unseasonal exuberance among European issuers it is the actions of the European Central Bank. In its May policy meeting it announced that from July it will make purchases of European covered bonds of up to €60bn. This ray of sunshine provided a much-needed boost to both issuers and investors, even though many questions remain regarding the details of the initiative – not least the price the ECB is willing to pay for its investments.
Other central banks have indicated their support for covered bonds, for example, via the Special Liquidity Scheme in the UK and the Financial Assets Liquidation Fund in Spain. The ECB extended the maturity on its repo transactions to 12 months, meaning covered bonds could be used as collateral and banks could borrow for longer, freeing them from the need to constantly roll over their positions. In an environment where complexity is spurned and simplicity is king, many believe covered bonds will remain a currency of choice for central banks.
The crisis has transformed the industry in terms of its relationship with investors. Banks have become the most important investors in covered bonds, attracted by the low risk weighting and the recourse to the underlying assets, not to mention their utility as a currency in dealing with the ECB. Fund managers have gravitated to the shorter dated issues, while institutional investors have taken the longer dated bonds – to a much larger extent than was seen before the crisis took hold.
An interesting paradox in all this has been the disconnect between the timing of the ECB announcement and the simultaneous glut of issuance with the broader performance of the asset class. Rating agencies are reviewing their rating methodologies and are hawkishly watching the bonds they rate: a wave of downgrades is on the cards.
Yet the overall picture remains relatively positive. A market that is still almost exclusively European looks set to extend its borders: the first deal has been completed in Asia and the US, which has seen false starts in this market before, is again looking at how it can establish a market as a way of reducing the cost of mortgage financing.
It looks like covered bonds are back. But whether these green shoots of recovery can blossom into something more substantial remains to be seen.