Michael Weigerding
COVERED BOND
RESEARCH TEAM
Michael.Weigerding@
commerzbank.com
Covered Bonds:
What does the
year ahead hold?
Commerzbank’s Michael Weigerding looks at trends in the covered
bonds market for the year ahead.
Amid falling oil prices and economic slowdown in China,
covered bonds have been one of the rare asset classes that
have been fairly unaffected by the market turmoil at the start
of the year. Supported by continued ECB buying and their
low-risk structure due to dual recourse, the sector has seen
spreads hold firm since late January.
But that’s not to say 2016 won’t be without certain
challenges. Below we take a look at the key themes which
we believe will characterise the international covered bond
market over the rest of 2016.
ECB buying continues to support market
As part of its ongoing quantitative easing programme, the
European Central Bank (ECB) should continue to be a heavy
buyer of covered bonds in 2016 and on into 2017. By the end
of 2016, we estimate the ECB may hold up to 20% of eligible
covered bonds while its share in the eligible benchmark
segment could rise to 30%.
However, the ECB’s buying patterns for covered bonds have
seen an important strategic shift in the last year. Purchases
have shifted from 80% in the secondary market to a more
even split between primary and secondary markets. Given
reduced capacity in secondary markets this increased focus
on primary volumes should remain in place.
Investor universe impacted by lack of liquidity
Despite this trend, the lack of liquidity in secondary markets
is likely to be an ongoing theme in 2016. Liquidity was already
a topic before the ECB stepped in, but since the start of the
central banks’ third covered bond purchase programme
(CBPP3), we estimate trading volumes have dropped by a
third. We do not see this trend coming to an end soon as we
expect that the central bank will keep buying at the capacity
of the secondary market over the course of 2016.
As in 2015, this could limit demand for covered bonds
among real money investors, such as asset managers,
who require a certain amount of liquidity for active portfolio
management. As a result, new issue order books with 100+ of
genuine investors have already become a rarity. Luckily,
however, covered bonds have come to look significantly
more attractive again in relative value terms, which has
contributed to rekindling investors’ interest in the asset class.
Spreads vulnerable to greater volatility
As liquidity continues to be scarce we should expect to see
more volatility in covered bond spreads though. As we saw
in 2015, this is likely to be a particular issue towards quarterends when market makers are seeking to reduce their
exposure. For example, excluding the year-end, last year
the trading volume in peripheral covered bonds typically
decreased by more than a fifth towards the last week of a
quarter. This scarcity also affects segments not eligible for the
CBPP3. Despite the covered bond sector’s relative stability in
the face of macro-economic turmoil, such increases in spread
volatility could again reduce its attractiveness for investors.
Of course, ECB buying should provide substantial support,
but as we have seen in the past, the central banks do not
necessarily immediately step in when spreads are widening.
Extendable maturities becoming the norm
In terms of product trends, soft-bullet maturities, where
redemption dates can be extended under certain
circumstances, should continue to see their popularity grow
this year.
Extendable maturities have become increasingly appealing
to issuers seeking to manage their over-collateralisation
requirements. As extendable maturities give the pool
manager more time to sell assets after an issuer insolvency,
soft-bullet structures might assure a higher recovery value
and greater ratings stability. In terms of spread differential
there is no significant difference between hard- and softbullet structures.
There are only a few frameworks left in Europe that do not
make use of extendible maturities for covered bonds on a
broader scale; in particular Spanish Single-Cédulas, Austrian
covered bonds and German Pfandbriefe. However, 2016
could see Germany move its Pfandbrief framework towards
a soft-bullet regime. Given the country’s dominance in the
euro benchmark market, this would substantially accelerate
the structure’s market penetration.
Strong property markets to increase supply
With the ECB continuing to buy around 30%-40% of all
CBPP3-compliant new covered bonds, this remains a wellsupported market for issuers. At the same time ongoing low
interest rates should continue to underpin mortgage markets
while keeping a lid on demand for private placements. As a
result, we should see overall euro benchmark covered bond
supply 2016 increase slightly compared to 2015. With more
than €50bn already placed, the start of the year has indeed
been promising in this regard.
Newcomers continue to contribute to a more diversified
issuer universe. In Asia, notably in Singapore and Korea,
banks show increased interest in the sector, as are debut
issuers in various established markets.
Harmonisation – time to wait and see
Finally, the European Commission’s plans to harmonise
European covered bond frameworks should continue to
produce headlines this year. But with the actual legal
implementation not due until 2017, they are unlikely to
already affect spreads any time soon. In principle, for
countries with a weaker regulatory framework harmonisation
should be good news in terms of investor demand. In the end,
however, the devil will be in the details.
Covered bonds: What does the year ahead hold? March 2016
2
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