The European Central Bank’s third covered bond purchase programme (CBPP3) has had a devastating impact on private sector demand for covered bonds since its start in October 2014. With the ECB regularly buying half or more of primary deals issued by eurozone banks, the number of private investors and the overall level of demand have fallen sharply.
Last year Compagnie de Financement Foncier issued four euro benchmarks, which on average attracted 111 investors each. This year the French financial institution has attracted an average of 73 buyers across five deals. UniCredit tells a similar story: the number of investors buying its covered bond deals has fallen from an average of 115 last year to 57 this year.
The two issuers are emblematic of the market as a whole and have also seen a substantial contraction in the scale of demand for their covered bonds. The average oversubscription ratio for both issuers’ transactions fell from 2.7 times to 1.5 times this year. The trend is heading lower still, especially in peripheral Europe where a succession of recently issued Spanish and Italian transactions were barely covered.
Many investors say the return they get is too low especially in the lower yielding core European market. And with limited performance potential they would rather invest elsewhere. “It doesn’t make sense to invest in core covered bonds trading up to 20bp tighter than non-CBPP3 eligible bonds with similar or in some cases better credit metrics,” says Kristion Mierau, a senior portfolio manager at Pimco in Munich.
In mid-October a typical five year German Pfandbrief issued by a single-A rated bank was trading at 8bp through mid-swaps compared to 23bp over mid-swaps for a typical double-A rated five year Australian covered bond.
The difference in spread is largely explained by the actions of the ECB. As of October 16 it had bought €126bn of covered bonds under CBPP3. Putting all the three programmes together, it owns €158bn, or 21% of the outstanding euro benchmark market. When CBPP3 is scheduled to end in September 2016 (it might in fact be extended, depending on what the ECB says in December) the central bank will own roughly 35% of the benchmark eligible market.
“In the current environment, I’m not sure if the ECB will stop buying in September 2016 as inflation and world growth aren’t moving in the right direction,” says Ralf Grossmann, head of covered bond origination at Société Générale in Frankfurt.
He says the ECB is trying to behave as much like an investor as it can, but says that it must fulfil its pledge to buy €60bn a month under the CBPP3 and public sector purchase programmes.
However, Grossmann is broadly optimistic that private sector demand will revive as spreads are now back to levels last seen before the CBPP3 was announced. “For issuers the levels are still OK and from an investors’ view we’re moving back to territory that should be starting to get interesting.”
But the day will eventually arrive when the central bank begins to withdraw stimulus. Though the spread reaction is likely to be negative, bankers expect a typically stoic reaction from the covered bond market.
“The ECB’s gradual phasing out of CBPP3 should be accompanied by a steady widening in spreads which will re-engage those investors that were lost when spreads had been tightening,” says Armin Peter, global head of syndicate at UBS in London. Peter believes the repricing of covered bonds will be less severe than other asset classes “because it’s a lower beta product”.
Though covered bonds do not offer tremendous income their resilience amid market volatility has seen them perform quite well this year, according to Markit, which in July said that covered bonds had beaten the corporate sector by 1.48% and the sovereign sector by 0.83% since January.
A core source of financing
Covered bonds are therefore likely to be viewed as a valuable investment in any high grade portfolio because they have a stabilising influence when volatility rears up. And where there is demand there is supply.
“Covered bonds were more important in 2011 when other markets were too expensive or closed, but they’ll never go away as a core financing product,” says Grossmann. “Covered bonds make sense for issuers because funding costs are low, and they make sense for investors who will always have a need for high quality alternative assets to government bonds and agencies.”
Primary issuance volumes have fallen from 2011 when the equivalent of $311bn was raised in the first nine months of the year, compared to $140bn in the same period this year, according to Dealogic. But for the past three years volumes have been fairly steady, increasingly slightly this year as volatile market conditions crimped senior unsecured issuance. During periods of higher volatility covered bonds offer lower execution risk compared to senior unsecured.
This was all too evident in Europe this year when concerns over Greece and the outlook for US interest rates caused the Markit Senior Financials index to almost double from 53bp in early March to 100bp in July. With the level still at 97bp in early October senior issuance remained subdued going into the final quarter.
“Covered bond volumes never really left, nor will they. In fact, euro covered bond supply from European banks has exceeded senior issuance so far this year,” says Peter. According to UBS’s syndicate team, euro denominated senior unsecured supply from European banks was €93bn in the first nine months of 2015, 14% less than the €108bn of covered bond supply seen over the same period.
Though markets have begun to stabilise, European borrowers continued to favour covered bonds over senior issuance in October. But over the next year bank treasurers are expected to be more focused on capital rather than senior or covered bonds, says Grossmann. Since capital deals also provide funding their need to rely on covered bonds is lessened.
Outside Europe, covered bonds are expected to remain a staple source of financing, especially in Canada, Australia and New Zealand. They could also become a core source of financing for emerging market countries like Turkey which has yet to issue, but has a covered bond law and several investment grade rated programmes.
After DBS Bank and Kookmin Bank issued the first legally enshrined Singaporean and Korean deals this year, other issuers should follow from these counties. Elsewhere, Tunisia, India, Brazil and Mexico are setting up covered bond regimes. And, after updating its law, Poland is expected to join the covered bond club in 2016. Covered bonds may therefore become an indispensable source of funding in many regions of the world over time.
Evolving structures and products
The fundamental financing provided by covered bonds may also be complemented by the market’s evolution, in terms of structure and product.
In late October the European Commission (EC) published a report which boosted hopes that new products could emerge. The EC raised the possibility of extending the preferential capital treatment, currently provided to the established mortgage and public sector assets that secure covered bonds, to other asset classes.
The EC said it wanted to consider whether covered bond eligibility set out in Article 129 of the Capital Requirement Regulation should be replaced “with a set of more comprehensive qualifying criteria” and whether this should include recognition of “secured instruments using covered bond-like structures backed by loans that fund non-financial activities.”
Non-financial activities include aircraft and shipping loans, as well as loans to small and medium sized enterprises. The EC said it was “very keen on striking the right balance between an adequate prudential treatment for covered bonds and other forms of secured lending” which could have “potential benefit in terms of economic growth” and would encourage “sound lending to the real economy on the back of covered bond-like technology using these assets as collateral.”
But whether these notes, which the European Covered Bond Council calls European Secured Notes (ESNs), ever become anything other than a marginal product remains to be seen. “ESNs may help provide a funding alternative to the regulatory disadvantaged ABS market, but banks are not in urgent need of funding,” said Peter before the ECB paper was published.
Grossman, for one, does not believe ESNs will ever become as mainstream as the established asset classes backing covered bonds. “Mortgage and public sector covered bonds are like big tankers,” says Grossmann. "They're only changing their course very slowly. That's why it takes a long time for innovative features such as the conditional pass through to gain ground.”
However, the conditional pass-through (CPT) structure, pioneered by NIBC in September 2013, could well take off. Removing refinancing risk following an issuer’s default, CPT bonds require less collateral to reach a given rating. Because of this it is possible for issuers to get a higher CPT covered bond rating compared to more traditional hard and soft bullet covered bonds.
This valuable feature makes the CPT structure particularly useful for lower rated banks. Several issuers have joined the ranks since NIBC launched its deal, including another from the Netherlands, two from Italy, three from Portugal and one from Cyprus. Moreover, under the newly amended Polish law all covered bonds could automatically switch to a CPT structure.
Grossmann says CPT removes the refinancing risk in a scenario where an issuer has defaulted, which results in lower overcollateralisation requirements and higher bond ratings, but he doesn’t believe CPTs will be quickly or easily adopted.
“It’s been relatively straightforward for issuers to switch from hard to soft bullets structures with consent solicitations but to convert existing programmes to conditional pass-through would be more challenging,” he says. He believes borrowers who want to issue CPT covered bonds would be obliged to set up entirely new programmes.