Standardised covered bond CDS being finalised are intended to serve as a hedge against spread moves rather than default, and any price volatility they may bring is the flipside of an efficient price transfer mechanism, according to a banker familiar with the initiative, who said it has gained interest from more banks.

Covered bond CDS have already been traded, but this has been by appointment only and a new initiative, in which Credit Suisse, Deutsche Bank and JP Morgan are involved, is aiming to standardise the product. (Click here for The CBR’s original coverage.)

Very little public comment has been made on the initiative from those involved, but it was a focus of discussion during a secondary market panel at the ICMA Covered Bond Investor Council & The Covered Bond Report conference last Thursday (10 May).

Covered bond CDS could, according to Richard Kemmish, head of covered bond origination at Credit Suisse, act as a price transition mechanism to help smooth over differences in the way relative value in covered bonds is viewed in the credit and rates markets.

Many investment banks have already traded covered bond CDS, he said, but this has been on the basis of “back of the envelope documentation”. However, a lack of standardised trading of covered bond CDS is a “recipe for disaster”, he added, with the drafting and status of CDS contracts in general already in “a confused state” given regulatory bail-in proposals and questions about the division of financial institutions into going and non-going concerns.

Whether or not market participants agree with covered bond CDS, at least the investment banks that are involved in the initiative are providing the product on consistent basis, in a “sensible and legally rational way”, said Kemmish.

The documentation is being finalised, he said, and will identify failure to pay as the trigger for payment. A small group of other banks have asked to join the initiative, which will become operational without great fanfare, he said.

In response to and in anticipation of other criticisms made of covered bond CDS, he stressed that the product is not being conceived as a hedge against default but as a hedge against spread moves, and that although covered bond CDS may allow more price volatility in covered bonds, this is “the flipside of an efficient price transfer mechanism” that is missing from the market.

It is only rational that volatility across the rest of the capital structure also be reflected in moves in covered bond prices, he suggested, adding that an efficient price transfer mechanism would also address the problem of unreliable secondary market screen prices serving as references for new issues. (Click here for previous discussion of the usefulness of secondary market prices.)

The most valid criticism of covered bond CDS, toward which he is “agnostic”, said Kemmish, is the risk of it being a one way market, with there being structurally more market participants wanting to buy than sell protection.

“Whether the growth of the covered bond product outside the traditional investor base will help address that, only time will tell,” he said.

Reactions from other panellists and delegates speaking from the audience included mildly approving comments that covered bond CDS could be something “marginally positive”, for example making easier certain relative value trades across the capital structure, and that fears about poor liquidity of covered bond CDS should also bear in mind that CDS of senior unsecured bonds is also “not that liquid”.

Ralf Burmeister, senior portfolio manager for covered bonds at DB Advisors, said that he is neutral to the idea of covered bond CDS, but that any involvement on his part would be subject to a legal check, a review of the product’s computability with investment guidelines, and important questions being answered about documentation and the definition of triggers.

Discussions earlier this year about whether or not a private sector involvement initiative in Greek government bonds would constitute a credit event and trigger sovereign CDS, despite that product having a longer history, was not necessarily that encouraging, suggested Burmeister. He also questioned whether covered bond CDS will bring about a “true improvement for pricing” and attract more investors, noting that the product is already available on a bilateral basis.

Matthias Herfurth, head of covered bond trading at UBS, said that CDS are not a very liquid product, with wide bid-offer spreads, for example, in sovereign CDS making it questionable whether it is a good hedging tool.

Conference delegates speaking up from the audience suggested that the covered bond market should first focus on improving liquidity in the underlying bonds before introducing standardised covered bond CDS, with one arguing that the latter will not be a liquid market as long as liquidity in the underlying market is poor. Another delegate said that liquidity is “a real issue” for the market and that while CDS are “fantastic”, no progress will be made on liquidity until price discovery is visible.

Jozef Prokeš, covered bond portfolio manager, BlackRock, said that liquidity in the senior unsecured market is also limited and that CDS is helpful there, while Kemmish acknowledged comments about the lack of liquidity in the underlying bonds as valid, but said that the banks behind the initiative have the view that if the cash market is relatively illiquid CDS should make the situation better, not worse.