Today’s new covered bond issuance suggests that a second European Central Bank purchase programme could provide just the kind of magic the markets sorely need. But the ECB should learn some new tricks if it wants to wow the markets anew and provide broader support for the banking sector – although this could yet include covered bond purchases.

When the original European Central Bank covered bond purchase programme (CBPP) was sprung on the market in May 2009, the covered bond market was dysfunctional.

The senior unsecured market was outperforming the purportedly safer asset class in terms of issuance and spread performance. Investors appeared to be giving insufficient credit to the extra security provided by the collateral backing covered bonds – possibly because of the asset class’s disappointing liquidity, possibly because government support programmes had eased fears about bank risk. Benchmark covered bond issuance in the year to the CBPP’s announcement had been less than Eu15bn.

A month ago, some Eu20bn of benchmark covered bonds hit the market in the space of just two weeks. Covered bond spreads have massively outperformed senior unsecured. With risks having fed through from the banking system to sovereigns in the past two years, investors are now paying a lot more attention to the collateral backing covered bonds.

Indeed the covered bond market has been functioning exactly as one would expect. So why embark upon a second round of covered bond buying?

It is questionable whether it would achieve the ECB’s broader policy goals given the scale of the problems facing the euro-zone today, as a possible expansion of the European Financial Stability Facility to Eu2tr implies. Action to address deteriorating sovereign fiscal and growth positions, coupled with a de-risking of bank credit is what is required.

Furthermore, the impact of the CBPP did not simply disappear when the last covered bond was bought. The ECB’s actions left the “fantasy” that it could return at some point in the future.

Regulatory developments have in the meantime bolstered demand for covered bonds in a magnitude that in the long run will quite easily surpass the Eu60bn previously bought by the ECB.

The timing – if the ECB is, as has been rumoured, to announce something in the coming week – is also questionable. Why should the ECB take any firm action regarding bank funding when a package of measures designed to support the European banking sector appears to be in the process of being created, but will possibly not be ready until early November? Until the impact of any such measures can be judged, it would be nigh on impossible for the ECB to predict what, if any, effect a second CBPP would have – in which case any follow-up programme would best be built with greater flexibility than the first, i.e. with no fixed timescale and no fixed amount.

But the ECB already has such an option at hand: the Securities Markets Programme.

Although this has been the tool with which the ECB has intervened in government bond markets, it can use the SMP to buy other bonds, too. And as with its purchases of sovereign bonds, it can – unlike the CBPP – take full control of buying rather than leaving it to national central banks, and get the most bang for its buck by focusing on peripheral markets where conditions are worst.

Indeed a switch of the SMP into the covered bond market would carry just the kind of magic of the original covered bond programme, and hold out the fantasy that the ECB could broaden its purchases into other asset classes – giving the wider bank funding market a much more useful boost than a mere repeat of the CBPP.