The emergence of a sellers’ market has raised questions about the validity of secondary market levels as pricing references, with covered bond bankers citing varied symptoms and remedies – some psychological, while a fund manager said that some prevailing practices are unsatisfactory.

DZ Bank analyst Michael Spies said that borrowers are able to dictate the terms of new issues because of the heavy pressure to invest that has resulted from the surplus liquidity made available by the ECB’s two longer term refinancing operations (LTROs) and difficulties in purchasing bonds in the secondary market.

“As a result, market standards are being established that have not existed in this form since the Lehman collapse,” he said, citing high bid-to-cover ratios, low allocation rates on order books, and the absence of new issue premiums.

Armin Peter, head of covered bond business and syndicate at UBS, agreed that issuers are in the driving seat for the first time in four years, and that market participants have occasionally been surprised by the strength of demand and how eagers investors are to “get their hands on” supply.

“So I think everyone understands that new issue premiums tightened,” he said, “and even though pricing through secondary levels was probably not something that people expected, it is also understandable that some transactions ended up coming tighter than what was felt to be the potential final outcome.”

DZ’s Spies noted that almost all of the new issues that have come to market have been in such strong demand that initial spread indications have been tightened by several basis points during marketing.

Compagnie de Financement Foncier, for example, in February priced a Eu2bn three-and-a-half year obligations foncières issue at 95bp over after having set initial guidance at 105bp-110bp over, and Société Générale at the beginning of March sold a Eu1.5bn seven year deal at 107bp over after having started with initial price thoughts of the 120bp over area.

A syndicate official at one of SG’s leads defended the spread development, saying that the transaction reflected broader trends in the market, with demand generally so high that there is “strong systemic oversubscription”, also in the senior unsecured and agency markets, with many deals reaching a final level considerably tighter than initial guidance.

However, he suggested that those executing deals still needed to be mindful of certain risks and sensitivities, and that although new issue premiums had recently shrunk from the higher premiums paid at the start of the year, lead managers still had to choose levels palatable to investors.

UBS’s Peter said that the key question for primary market pricing is how accurate secondary market levels are.

“There has been a clear change in balance between supply and demand,” he said, “which also always rotates around the question of where the secondary market is at that point in time in terms of the dynamics.

“Before you took your guidance purely from the secondary market where liquidity was arguably not the best because there weren’t necessarily enough bids, and now it has changed so you don’t have any offers, but the question remains: how much guidance do you take from the secondary market?”

Richard Kemmish, head of covered bond origination at Credit Suisse, said that the market has a “fundamental problem” in the way that market participants reference secondary market levels when discussing new issue pricing.

“That is dysfunctional at a time when you have a lot of illiquidity and price opacity and no real flows going through, in both directions,” he said. “We have a situation like that now when we know that covered bonds are probably materially tighter than what the screens show, but we can’t do anything about it because we’re too psychologically attached to those numbers.”

Double-digit tightening from initial price thoughts to a final reoffer spread and subsequent further tightening in the secondary market has been a feature of several benchmark transactions this year, and is a reflection of this problem, said Kemmish, “even with syndicate desks being aware of all these factors, and knowing where demand is”.

Achim Linsenmaier, head of covered bond syndicate at Deutsche Bank, said that the usefulness of secondary market prices depends on who much liquidity there is in particular bonds and how these trade.

“Some bonds are only marked and do not trade or investors aren’t interested in them because they can’t get enough of them or because prices are above par,” he said, “and that is problematic at times.

“A lot of so-called secondary market prices are nothing more than marks, and therefore have to be taken with a big pinch of salt.”

UBS’s Peter said it is difficult to avoid referencing secondary market levels, but that it is important to value differences in issuers’ credit quality and to take into account recently launched transactions.

“Particularly for smaller issuers, who don’t come to the market very often, you can question the liquidity of the outstanding curve and how correct those secondary curves are when there hasn’t much trading going through,” he said.

A new aspect in the secondary market, added Peter, is “a differentiation between the on the run/off the run theme”.

He said that there is a “below-par-effect”, depending on the coupon of an outstanding bond, that is not something to be underestimated.

“Investors have an interest in buying bonds that are trading below par and in the low yield environment we have now most of the outstanding bonds trade well above par,” said Peter. “Some investors who make an investment and buy bonds well above par but receive par upon maturity would have to take a loss, and that makes a bit of a difference in demand dynamics and value for them.”

Kemmish at Credit Suisse suggests that the covered bond market needs a shift in psychology to better handle changes beyond interest rates.

“The credit market doesn’t have this problem, possibly because it is used to coping with news, headlines, and changes to the world other than Bund futures,” he said. “Historically we have mainly tended to react to interest rate movements.”

Price transparency could also be improved if market makers sent more ranging shots, according to Kemmish.

“Dealers in the credit market show smaller tickets to each other and then find a new level in response to news,” he said, “whereas in covered bonds we tend to retreat and avoid showing two way prices as readily.”

This is partly a psychological relic of the inter-dealer market making agreements, according to Kemmish, which has left market makers reluctant to show wide bid-offer spreads for fear of being unjustly criticised by issuers and origination colleagues.

But he held out the prospect of a shift in trading behaviour.

“The idea that fewer and fewer bonds are triple-A and that there is more and more correlation to both govvies – to the extent that govvies are credit – and unsecured bonds, should ideally cause some form of convergence of trading patterns,” he said, “although whether that will happen or not is unclear.”

Deutsche’s Linsenmaier said that the lagging of secondary market levels makes it all the more important to retain deal execution flexibility via the use of initial price thoughts to gather indications of interest.

But Daniel Rauch, fund manager at Union Investment, has little time for the practice of shadow bookbuilding, in particular given what he said was an extraordinary provision of liquidity via the ECB longer term refinancing operations (LTROs) and the associated establishment of a seller’s market.

“When you consider the market backdrop against which the use of shadow bookbuilding and IOIs developed, in the aftermath of Lehman Brothers, there was a clear rationale for this approach to deal execution,” said Rauch.

But this rationale has been undermined by the prevailing market situation, he said.

“Nowadays there are no problems whatsoever to place a new issue, yet the practice continues,” he added. “We have no sympathy for this.”

He pointed to a Eu500m seven year Deutsche Bank Pfandbrief as an example of how exaggerated the practice can be.

The issuer priced the transaction late in the afternoon of 22 February, accelerating deal execution that had been foreseen for the following day on account of the strength of demand that was registered when the leads took indications of interest.

Orders reached nearly Eu1.5bn before the order books were officially opened, with the final order book standing in excess of Eu2bn. Rauch said such high demand should have been expected, and that the transaction serves as an example of just how unnecessary shadow order books are in the prevailing market.

However, he said that investors also have to take responsibility for their role in allowing such behaviour, including with respect to deals pricing through secondary levels and coming at considerably tighter levels than where they are initially marketed.