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IPTs ‘comedy’ lamented, but leads stress risk of alternative

As successive deals are launched with tempting IPTs only to land far tighter, each day in the euro covered bond market is Groundhog Day, say investors. However, syndicates warn that tighter IPTs could kill deals’ momentum, meaning investors, and issuers, lose out.

Last month we published an opinion piece by a leading German investor who called for more “realistic” pricing practices in the covered bond market. We gathered further opinions from the buyside and let the sellside have its say.

Several large investors that spoke to The Covered Bond Report agreed with their German peer, saying that given the current stable conditions in the euro covered bond market, the imbalance of supply and demand and ongoing CBPP3 purchases, there is no reason for issuers and their leads to use pricing practices developed during a time of crisis.

“The behaviour of the issuers and leads in the primary market is ridiculous,” said a major German bank treasury investor. “It is like a stand-up comedy, or like Groundhog Day, because the pattern is always the same.”

Investors noted that most euro benchmark trades in recent weeks were launched with initial guidance 4bp-5bp back of fair value, and then – after strong growth in the books – guidance was revised to much closer to fair value, before the deal was ultimately priced with little to no new issue premium.

They said large deviations from IPTs are understandable for first time issuers or amid less predictable market conditions, but that issuers and leads could under prevailing conditions easily launch most deals with more “realistic” guidance.

“The leads are of the opinion that a bookbuilding spread tightening from IPTs to final spread of 4bp or more is a huge success,” said the bank treasury investor. “They are wrong. It simply shows that they do not know their customers and the market.

“A huge success for a lead bank, from my point of view, would be setting the right guidance with a 2bp range and pricing within. And this is not science.”

A common retort from the sell side is that more investors should limit their orders and drop out of books when a deal is tightened beyond the level they deem reasonable. This, they say, would give lead managers and issuers a better idea of their expectations.

“Investors can vote in the bookbuild – they are not forced to accept any price,” said a syndicate banker. “If the majority of investors set limits, then the price would stay.”

But investors say this is ineffective, partly because the buyside is made up of various investor-types with different opinions, needs and pressures.

“Even though, of course, we could limit the new issue orders, the IPT is a main factor in our analysis and is critical for our decision to set up the security for subscription in our portfolio management system, a process that takes time and utilises resources,” said a German asset manager.

“Hence, we are likely to avoid issuers that showed large deviations from the IPT in the past and dedicate our time and effort to those that give a more realistic initial guidance.”

Indeed, contrary to what several syndicate bankers assumed, investors’ complaints focused not on ultimately “tight” pricing, but the pricing process and the movement in spread therein.

Most investors that spoke to The CBR – typically larger, more experienced players – said they account for expected moves from initial guidance by waiting until later in the execution process to place their orders, until either revised guidance or the final spread has been set.

“Our way to cope with this issue is to try to attach an intrinsic fair value to a primary deal, not communicating it with the lead banks, looking at the initial IPTs and trying to estimate the issuer’s leeway in terms of final spread,” said another German investor. “Currently this leads to the result that we are not in the books right from the start.”

A non-German bank treasury investor, who tends to wait until the final spread is released before making a bid, said this would probably not happen in a more balanced market.

“As a bank that swaps the bonds, negative spreads are tricky for us anyway,” he added. “Keeping spreads for a long time above swaps and then in the end dropping them below the swap rate reduces appetite further.”

Unnecessary risk, or a right to fail?

Some syndicate bankers conceded that the pricing process appears redundant if deals are successively and predictably priced at or close to fair value after IPTs several basis points wider, and that a change in approach could make the process feel less painful for investors. However, they said their primary duties are to issuers – to ensure new issues are smoothly and successfully executed – and that issuers have a responsibility to secure the best price realistically available.

With issuers in a “massively comfortable position” due to the supply/demand imbalance, the strong performance of all recent deals, and the range of funding options available to them, there is little incentive to change current practices, they said, noting that even those investors that complain continue to buy.

“There’s a sense people are saying ‘you are idiots, you are fooling us’, and then staying loyal to the book,” said one. “No one who is a professional investor can bear the consequences of staying sidelined.

“If you are a covered bond fund manager, you probably have no other option – just buy what is on the table, unless you think it is foolishly wrong. Je regrette, mais c’est la guerre. This is what happens.”

Furthermore, some syndicate bankers argued that the proposed pricing model – to open books with initial guidance closer to fair value or a fixed spread range – would increase the risk of deals failing.

One syndicate banker recalled an example of a Eu1bn 10 year trade from a prominent covered bond issuer this year that, he said, was consciously launched with “a more realistic approach, to use investors’ words”, while still offering a new issue premium versus the issuer’s curve.

“Exactly these investors that are complaining were waiting for the first book update before they put in their orders,” he said.

The first book update announced that books were approaching Eu1bn, with guidance unchanged. However, some investors then dropped out of the book, while other investors that had previously indicated their interest did not come in.

“These investors said that the bookbuild was slow, that there would be no oversubscription,” he said. “They say, if it does not perform on the primary, it will not perform on the secondary – so they don’t want to buy it.

“Many of them only put in an order after the first book update and only if they see that momentum.”

Issuers are also well aware of this risk, he said, and are keen to avoid a slow bookbuild by showing wider guidance at the start.

Another syndicate banker noted that a series of recent taps of German Pfandbriefe have followed a similar approach, with leads announcing the deal at a fixed spread. On the whole, this approach had worked, he said, even though the deals were priced at or marginally wider than fair value.

“But I doubt that this works for a benchmark, nor do I think it’s the better way from an investor’s view,” said one. “What do they win, rather than running the risk, too, of getting stuck with a trade that eventually doesn’t work at the tighter start?”

Another syndicate banker noted that a recent corporate bond issue had struggled to gain momentum after being launched with guidance in a fixed range.

“Investors might ask for this change in our behaviour but then not fulfil their end of the bargain,” he said. “The whole investor community is not yet ready for this behaviour.”

A German investor countered this argument, stating that due to the predefined range of investors that will buy most eligible new issuance – from the Eurosystem to LCR buyers – a new issue is only truly likely to fail if the price is wrong.

“And in such a case a bond has a right to fail,” he said.

He added that if a bond is not substantially oversubscribed, the spread level should also not be squeezed, and therefore should still have a good chance of performing on the secondary market.

“Does a bond always need to have a huge oversubscription?” he said. “Is a normal functioning book, a bond placed at a fair level with 1bp-2bp NIP – so investors can earn some performance on the secondary market and with good allocations for all participants – not a great thing?

“Are happy investors not of any worth for issuers anymore? Is a deal really only a good deal if syndicates can blow up the book as much as possible with unrealistic IPTs so the issuer was able to squeeze the bond as much as possible? If yes, it’s a poor sign.”

An extended version of this article – incorporating issuer input – will feature in the next issue of The Covered Bond Report magazine.

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