A month before the October 2014 start of the European Central Bank's covered bond purchase programme, Compagnie de Financement Foncier issued a five year covered bond benchmark at 5bp through mid-swaps, a feat that until then, many considered improbable.
The tightly priced deal also happened to be the most highly oversubscribed covered bond of the year.
The market had seemed overvalued at the time, but with the European Central Bank poised to commence purchasing the following month, and with net negative covered bond supply set to grip the market, the extraordinarily strong technical backdrop allayed fears of an imminent or long lasting correction.
In January 2015, the same issuer returned with a 10 year at 7bp over mid-swaps and an oversubscription ratio that was fraction of its September deal.
Then at the start of 2016, when the ECB’s largesse had extended to €145bn of covered bond purchases, representing more than a quarter of the entire benchmark market, CFF issued another 10 year at 25bp, more than triple the spread of the last 10 year, but which was barely subscribed.
It is just two weeks since the corporate sector purchase programme has got underway and it seems the eurosystem is well on the way to meeting its monthly target. But at €5bn the monthly amount being bought is only half that seen under CBPP3 for many months after it began. And as the corporate market is not facing the same degree of structural contraction that covered bonds were facing at that time, the technical backdrop seems comparatively less constructive too.
The markets seem to be moving together, despite the stronger credit protection built into covered bonds, suggesting corporate valuations are even more overstretched.
Take for example a single-A rated low beta corporate issuer like Unilever. A few weeks ago it issued an April 2024 at 28bp over mid-swaps, almost in line with where UniCredit Italy’s AA+ rated Obbligazioni Bancarie Garantite (OBG) due February 2024 was trading in the secondary market.
Earlier this month the A3/A- rated Air Liquide attracted a €12bn order book for its multi-tranche offering where the eight year piece priced at 48bp over mid-swaps. The deal was priced only 2bp wider than where Banca Popolare di Milano (BPIM) issued an A2 rated seven year a few days earlier.
OBGs, like most other covered bonds, generally have a higher credit rating because they are secured against prime mortgage collateral, exempt from a bank’s resolution and enshrined in a legal framework that is explicitly designed to protect investors’ rights.
Corporate bonds have none of these protections and if the Greek sovereign crisis is any guide, private investors will be subordinated to the ECB in the event of insolvency.
Peripheral covered bond valuations certainly look tight compared to other markets, with many participants believing the market is susceptible to a correction which could be precipitated on June 24 if the UK votes to leave the European Union.
If the Remain camp wins, this should precipitate a relief rally for blue chip corporates and covered bonds alike.
But with prices this stretched, it is questionable whether this bond bubble can be sustained much more beyond then, not least because a Federal Reserve rate rise will once again be back on the agenda. The covered bond purchase programme shows that even giant, technically distorting purchases cannot hold back market moves, and that markets tend to anticipate central bank buying, rather than be driven by the actual purchases.
The corporate purchasing programme may have only just begun, but it is only a question of when not if a proper market correction gets underway.