Covered bond market preps for hectic 2024

Covered bond benchmark issuance in euros had reached €175bn by early November 2023, suggesting the market was on track to reach €185bn for the year — somewhat less than 2022’s record of a little over €200bn. Although gross volumes are expected to decline a little in 2024, they are likely to remain well above average and, in the absence of central bank support, further pressure on spreads is expected.

In addition, after an unexpectedly dry primary market in the autumn of 2023, some banks will have deferred funding to 2024, suggesting the year will start on a lively footing.

“What we didn’t see in October and November is likely to turn up in January,” says Roberto Anaya, head of FIG syndicate at LBBW in Stuttgart.

After taking account of maturing deals and repayments to the European Central Bank’s Targeted Longer-Term Refinancing Operations (TLTRO), he says another busy year is in store.

At €117bn, 2024’s covered bond redemptions will be €7bn below 2023’s, but they are high enough to bolster investors’ cash reserves.

The cash being returned to investors will, however, be counterbalanced by a collective €450bn repayment of funding that eurozone banks borrowed from the ECB under its TLTRO.

Core European banks are generally well funded but, with the ECB expected to ramp up quantitative tapering — by halting reinvestments of cash from maturing deals under its Pandemic Emergency Purchase Programme — liquidity bottlenecks may ensue.

“Liquidity is going to be a strong focal point in 2024,” says Vincent Hoarau, head of FIG syndicate at Crédit Agricole in Paris.

Concerns about the predictability of deposit funding suggest “issuers will be more inclined to overfund than underfund”, a tendency that could be exacerbated by tighter regulation, such as a higher minimum reserve requirement, he adds.

A survey of more than 50 market professionals conducted by GlobalCapital for this report showed that almost half expected euro benchmark issuance of €175bn-€200bn in 2024. In total, 80% of the respondents worked for a financial institution and 90% were on the sell-side.

Euros provided the bulk of funding in 2023 and are expected to do so again in 2024. Even so, banks with a global footprint issued almost 40 deals in sterling, dollars, Australian dollars and Swiss francs in 2023.

According to Thomas Lowe, Nomura’s head of UK, Ireland and Canada FIG DCM, borrowers are expected to become more open to issuing in alternative currencies in 2024, as they offer “a genuinely diversified pool of investor demand”, typically not available in euros.

But doing so may require some issuers to update their covered bond programmes with new swap provisions.

The steep rise in interest rates, and emerging mismatches between newly issued liabilities and old cover pool assets, suggests issuers will be more inclined to put swaps in place within their covered bond programmes so they can hedge their rates exposure.

This effectively makes a cross-currency covered bond swap more of an “incremental” step, says Michael McCormick, head of EMEA FIG origination at Bank of Montreal in London, and that process is likely to be “less daunting” for issuers considering diversifying into other currencies.

The impetus to diversify should help to relieve supply pressure on euros, where spreads are likely to widen. S&P’s iBoxx euro covered bond index widened by about 10bp to 30bp in 2023 and 39% of survey respondents expect a further 5bp-10bp widening by the end of 2024.

Anaya says it is difficult to correct eight years of central bank distortion in one year but believes roughly 70% of spread widening has taken place. The remaining 30%, or 3bp, is expected to follow in 2024, he adds.

On the whole, universal banks with several business lines should be more able to pass this additional cost on to their clients, though this may not necessarily be the case with smaller monoline mortgage lenders.

Some banks are likely to be “unwilling or unable” to pass that additional cost on to their clients, says Patrick Seifert, head of primary markets and global syndicate at LBBW in Stuttgart.

As well as the sheer weight of supply, he says that pressure on covered bond spreads will also come from the sovereign, supranational and agency sector, where supply is also likely to be high.

Hoarau agrees that there is a big question over the market’s capacity to absorb sovereign supply and he is troubled that a prospective widening in SSA spreads will weigh on covered bonds.

On the other hand, the spread between banks’ covered bonds and senior preferred paper in most markets, except Germany, is tight — and that should help to contain a prospective covered bond widening.

Unless senior preferred spreads widen, there is a “limit to how far covered bond spreads can go,” says Shanx Tandon, head of EMEA FIG syndicate at Bank of Montreal in London.

But the fact that no issuer chose to follow Toronto Dominion’s €1bn eight year issued at the end of August with anything in the seven to 10 year part of the curve suggests a more material repricing could be due in tenors beyond the five year, once primary activity resumes.

Hoarau believes there is investor demand for long duration bonds issued by core eurozone banks, but many issuers are unwilling to pay the market clearing level to access this funding.

Seifert concurs that issuers’ ability to access the seven to 10 year area is simply a question of price. Banks with a strong credit profile will be more willing and able to pay up, he says.

Recent deals issued by Nordic and French banks in the five year part of the curve offered about 30bp over mid-swaps, but Toronto Dominion paid 54bp for its eight year at the end of August. Though core European issuers could expect to price tighter than Canadians, spreads have widened since TD’s deal was issued.

More importantly, demand for 10 year paper typically relies on interest from insurance companies. These buyers may not fully return until they are confident interest rates have reached a plateau.

Without this important group of buyers, demand for 10 year bonds will “crucially need to secure the bid from asset managers,” Siefert says.

These buyers are especially mindful of relative value and will simply not support a deal if they don’t believe it pays them enough. Equally, the new year will usher in fresh money, suggesting investors will be confident to strike a deal, he adds.

Two-thirds of survey respondents say they expect access to 10 year funding to open for longer periods of time than in 2023.

This view was partially informed by the assumption that the euro swap rate curve inversion that persisted throughout 2023 would revert to a positive slope.

Investors had little incentive to buy 10 year bonds in 2023 because euro swaps typically yielded 25bp less than three year rates and because issuers were not prepared to make up for that difference.

But with nearly half of survey respondents expecting the euro swap curve to end next year 25bp positive between the two and 10 year points, there will be a greater incentive to buy 10 year paper.

But, as always, timing will be critical. LBBW’s Anaya believes central banks will start to signal scope for an easing in monetary policy within the next two years, which is when the curve will begin to return to a positive slope.

Momentum for this move could start to build towards the end of 2024, but Anaya doesn’t expect a pronounced curve steepening until 2025.

Hoarau says he wouldn’t be surprised to see yields in the short end drop more rapidly in the first quarter of 2024, possibly following a credit event.

That tallies with 72% of survey respondents who thought geopolitical tensions in Ukraine and the Middle East would result in some issuers being unable to access funding.

A credit event may be unhelpful and could skew demand back into the short end, but in the long run it should normalise the curve, putting covered bonds on a strong footing.