Covered bonds to come under peer pressure in 2025

The covered bond market sits between rates and credit, and its spread relationship with both is set to define it in 2025. Participants expect that the pressure from widening SSA spreads, exacerbated by a narrow Bund-swap spread, will force covered bonds wider, new issue premiums higher and issuers into shorter maturities.

“Unless there are large, sudden spikes [in government bond yields] and central bank intervention on the back of that, the gradual widening and fiscal deficit-driven issuance of govvies will be the main story [in 2025], and through that, pressure will be put on covered bonds,” says Peter Wong, covereds and ABS portfolio manager at Nationwide Building Society.

Since the autumn, Bund yields have risen at a faster rate than swap rates, narrowing the gap between the two. The pair inverted for the first time ever in early November as Germany’s coalition government collapsed. As of mid-November, the 10 year Bund-swap spread was minus 6bp, according to Tradeweb, having started the year in the low 50s.

The movement in the Bund-swap spread “is driving SSAs and setting the floor for covereds,” says Florian Eichert, head of covered bond and SSA research at Crédit Agricole in Frankfurt.

What happens to the relative value between covered bonds and SSAs is for Eichert “the only real concern” for the covered market. “In most of core Europe, covered bonds haven’t really adjusted,” he adds. “The question is where do you start the new year? We need a clearing level for names like the EIB, KfW or EU, and then figure out where we go from there.”

With the gap between the two products narrowing, covered spreads will likely have to widen at a faster pace next year if issuers want to attract investors away from SSA paper. Of the market participants polled by GlobalCapital on their expectations for next year, 63% expect the relative value between covered bonds and SSAs to widen next year. Only 15% expect the differential to remain the same, with 22% anticipating tightening.

“In a normal market, I would have expected covered bonds to stay where they are and rather see spreads for credit widen as I think these are far too tight,” says Thomas Cohrs, Helaba’s head of FI and SSA primary markets in Frankfurt. “But with the dynamic between Bunds and swaps, and SSAs and covereds, covered bonds might need to widen in line with SSA curves to stay attractive.”

Ralf Löwe, head of treasury at Aareal Bank in Wiesbaden, agrees: “There is fundamentally good sentiment for credit, but for liquidity products — SSAs, govvies, covered — there’s more volatility. Personally, I think this is not due to weakness in covered, but rather from the cheapening of govvies and SSAs versus swaps.

“I don’t really see the potential for huge spread tightening in covered bonds in the near term, and if there’s a huge new issue volume early 2025, we might even see further widening,” he adds.

In fact, only one respondent to GlobalCapital’s covered bond market survey believes that covered bond spreads could tighten in 2025. Meanwhile, 59% expect them to widen.

Wong does not “foresee French, German, and UK govvie spreads richening anytime soon”, and as a result, this will drive “SSAs wider, consequently pushing covered bonds wider as accounts rotate into SSAs.”

“In 2025, banks will still be able to find demand for covered bonds but there might be a little more scarcity of investors because a lot of accounts than can shift to SSAs prefer them as the product is cheaper when compared to covered,” says Frederik Kunze, floor research at Nord LB.

“As a bank treasury investor, I don’t have to pay or put in equity when I buy SSA or agency bonds, which is something I must do when I buy covered,” adds Olaf Pimper, portfolio manager at Commerzbank’s treasury in Frankfurt. “From a risk return perspective, it doesn’t make sense to buy covered at the same level as SSAs or agencies.”

Not only are covered spreads expected to widen in competition with SSAs, but so too will new issue premiums, which are anticipated to rise — or at least remain elevated — in the face of cheap SSA competition.

“If SSAs, for example, come cheaper [in Q1] versus swaps, then obviously, I would expect pressure on covered bond spreads to remain,” says Löwe.

That pressure could result in high new issue premiums next year. Just 4% of survey respondents expect euro covered new issue premiums to tighten, compared 52% who anticipate no change from their now wider levels. Another 44% expect them to widen further.

“On paper, premiums might appear to be in the double digits but given how fast moving and volatile the market is now, there’s zero value in premiums,” Eichert says: “On paper we always have higher premiums at the start of the year, and in 2025 they may be even bigger than normal. However, they will, of course, appear that way because secondary levels won’t have moved up as much as they should have.”

In January, benchmark euro funders had to offer on average 5.5bp of concession, compared to 6.9bp in January 2023, according to GlobalCapital’s Primary Market Monitor. However, spreads came down in the following months, hitting year lows of 2.8bp in February 2023 and minus 0.8bp in March 2024 as the market digested the first barrage of supply and volumes slowed.

Nord LB’s Kunze anticipates a similar move at the start of next year: “I expect we will start with high NIPs well above 5bp-6bp, but as the secondary curve adjusts, they’ll move back to 4bp-5bp, which is much more reasonable for the market,” he says.

Although covered bonds are under pressure from SSAs across the curve, the damage is expected to be felt the most at the long end, particularly at 10 years and beyond. Various factors over the last few years — from elevated rates to geopolitical uncertainty — have forced covered borrowers into the belly of the curve. And unfortunately, for duration starved covered funders, the market anticipates that the long end of the curve will not be easily accessible going into 2025.

“For a strong year, you want to have the possibility for 10s and beyond, not just during small windows,” says Patrick Seifert, head of primary markets and global syndicate at LBBW in Stuttgart. “In the long run, issuing just threes and fives is not supportive for the covered bond market at its best.”

“That part of the market was open between January and May, but it’s not there anymore,” says Alberto Maria Villa, head of FIG syndicate at UniCredit in Milan. “The 10 year became very difficult to execute after the European Union elections [in June] and so far till now, that remains the case.”

In fact, only one issuer has so far accessed the 10-year part of the curve since June — Deutsche Kreditbank, which placed a €500m 2.75% October 2034 social deal at 39bp over mid-swaps in late September, pricing flat to the EU’s bond curve.

“To be frank, it’s almost a debut deal if you look at 10 years as we haven’t seen one for a while in a lot of jurisdictions,” says Kunze. “I expect issuers would have to pay a premium.”

“If the EU keeps issuing long-end bonds at the spreads it is now, then there’s rather less attraction in covereds,” says Cohrs. “They just can’t match that from an issuer’s perspective. I’d be surprised if we saw a resurgence of long-end covered bonds in this environment any time soon.”

Pimper adds that at the long end of the curve, he prefers SSAs: “when the spread is the same, it’s a no-brainer.”

Just over half of those surveyed (56%) expect 5.1 to seven years to be the most popular tenor for borrowers next year. No participants expect supply 10.1 years or longer to be the most popular maturity bucket.

There “is the need to find an acceptable and executable risk at the right spread, which is at the belly of the curve now,” says Villa.

“If spread differentials remain where they are, then it’s likely issuance will be concentrated at three to five years, which is slightly longer than the past three years but not by much,” Cohrs says.

Banks issued covered bonds with an average tenor of 6.3 years in 2024, up from 5.1 years the year before, according to PMM data. This year’s supply has ranged from two years at the short end to 15 years. However, the average tenor in 2024 dropped in the latter half of the year, from 6.7 years in the first half to 5.1 in the third quarter and 4.7 years in October.

“For issuers outside the eurozone, I’d say five years is a safe bet,” says Seifert. “It’s the deepest pocket of demand.”

Seifert is more bullish on what is possible in the eurozone: “I have a bolder view for the eurozone, and that’s 10 years. If 10 years works, there will be demand as issuers make up for missed opportunities this year and look for the best value for their collateral. Banks can do good fives or sevens in senior; the value for covered is in 10s and beyond.”

Although the return of longer dated issuance seems unlikely in the immediate future given the eye-watering spread such a deal will likely require, supply later in the year is not entirely off the table. “New movement in rates in 2025 may allow reopening of the long end again,” says Villa.

More than half of respondents (54%) believe that four to six issuers will tap the covered bond market for the first time in 2025, with a further 23% expecting even more debutants. “There is no reason not to debut if you’re preparing one,” Seifert says.

This year was a strong one for euro debutants, with several borrowers successfully tapping the public covered bond market for the first time.

For instance, Standard Chartered raised €1bn split equally across two trades — one in May and another in September — to fund its Singapore mortgage book. “I first visited Standard Chartered in 2015 and they did their first deal this year after nine years of work,” says Seifert, whose firm arranged the bank’s debut deal. “I’d like to not rule out that we might see a sixth name out of Singapore,” he adds.

Maybank was another debutant from Singapore.

Other Asian markets are tipped to explode next year, with Japan one to watch. “I understand there’s potential for Japan to support a proper covered bond law in 2025,” says Cohrs. “If that’s the case, then I’d expect quite a bit of issuance.”

The country does not yet have codified covered bond legislation. Instead, any issuers used the less-popular structured covered bond format to access the market. This structure — which uses residential mortgage backed securities as collateral — necessitates a higher spread and appeals to a smaller group of investors.

Only two Japanese issuers have established quasi-regular funding programmes in euros since the country’s first covered bond in late 2018: Sumitomo Mitsui Banking Corp and Sumitomo Mitsui Trust Bank. As of mid-November, the pair are yet to issue in 2024, though they raised €1.75bn in 2023, according to PMM data.

Japanese banks will not access euro covered bonds to finance their domestic mortgage market, for which they rely on deposits, but to raise foreign currency funding. Other Asian issuers could follow. “I see Asia as potentially the greatest growth area for covered bonds,” says Cohrs.

Asian banks have raised €6.4bn of benchmark euro paper in 2024 — over €2bn more than last year, according to PMM data. All this year’s issuance to date has come from Singaporean and South Korean banks.

Elsewhere, market participants foresaw more issuance from southern Europe, naming Portugal and Greece in particular. “I would expect to see at least two issuers return from Greece next year,” says Cohrs.