As of the end of January banks will have the option to pay back money borrowed under the ECB’s LTROs and market participants say that that such a move could make sense for issuers and counter negative covered bond supply dynamics. However, forecasts about the impact this could have are complicated by the variety of considerations banks will need to take into account when deciding whether or not to repay.

Euro-zone financial institutions borrowed just over Eu1tr via two three year longer term refinancing operations (LTROs) held by the European Central Bank on 21 December 2011 and 29 February 2012, and can return any money borrowed under the LTRO tenders on a weekly basis starting 30 January 2013 for the first tender, and from 27 February for the second tender.

Repayment of LTRO money does not necessarily have to translate into capital markets issuance as it could be linked to deleveraging, but as attention turns to the supply outlook for 2013 the prepayment option has market participants considering the prospects of it boosting supply due to issuers replacing LTRO loans with market funding.

Richard Kemmish, head of covered bond origination at Credit Suisse, says that prepayment of LTRO funds, which regulators – at least in some countries – are pushing to be replaced, is one reason why 2013 benchmark covered bond issuance volumes will be higher than might otherwise be expected.

For many issuers there is a strong case for replacing LTRO funding with market funding, he says, given that yields on most core covered bonds of up to five years, and even longer in the case of German Pfandbriefe, are lower than the prevailing cost (0.75%) of borrowing under the LTROs.

“Repaying the LTRO makes more sense for more issuers every day as spreads tighten and the LTRO loans become shorter dated, becoming two year funding,” says Kemmish. “We are a long way from NSFR [Net Stable Funding Ratio] implementation, but that doesn’t mean that banks can do what they like.

“Issuers need to term out and in some countries, though not all, there is pressure to do so, and in others it makes perfect sense to lengthen maturity profiles either from a cost to debt perspective or from an efficient use of collateral perspective.”

By coming at 20bp through mid-swaps and with a yield of 0.228%, a Eu500m two year deal from Münchener Hypothekenbank at the end of November illustrated how a public issue can be cheaper than keeping LTRO funds, even though the issuer said replacing LTRO funding was not the motivation for the deal.

“The first prepayment date is the end of January, so if this were a replacement you would have to have the proceeds on your books for two months,” said Rafael Scholz, head of treasury at Münchener Hyp, at the time of the transaction.

“I can imagine it being a motivation for some issuers early next year, and our deal will in that sense serve as a useful reference, but for now it is too early to talk about replacing LTRO funding given the carry costs.”

Don’t get carried away

But while refinancing LTRO loans in the market may be a profitable exercise for some issuers and could counter negative net issuance next year, the likelihood of banks returning LTRO money and the impact this might have on supply should not be overestimated, say market participants.

“There’s a lot of hype about the LTRO being up for repayment,” says Armin Peter, head of covered bond business and syndicate at UBS. “A lot of funding was taken out through the LTROs in 2012 so replacing that may work against the trend towards lower funding needs and reduced supply, but I’m not expecting a wave in the first quarter because of it, and certainly not one that will weigh on spreads.”

DZ Bank analysts say that replacing funds from the LTROs with new covered bond issues is only likely to make sense from a business point of view if the bonds can be placed at spreads that are, in their words, adequate for the bank, and that overall, this does not appear to be the case.

“At the moment, the yield premiums that would have to be paid by many banks on new covered bond issues are likely to lead to higher funding costs compared with the ECB tender,” they say. “Against this backdrop, for the time being we do not expect to see many new issues explicitly aimed at replacing LTRO financing.”

Crédit Agricole strategists think that for the coming year most banks will keep their LTRO money due to debt redemption pressures and the cost of funding in, or lack of access to, capital markets.

“On balance, after considering the data and the likely mood of ongoing cautiousness, we believe they will return initially Eu100bn-Eu150bn by the end of H1 2013,” they said. “This could accumulate to Eu200bn-Eu250bn by end-2013.”

Based on a poll of banks conducted after the third quarter reporting season, Morgan Stanley analysts expect banks to return around Eu80bn in the first quarter of 2013, rising to Eu160bn in a bull case. Well over half of the repayments will come from northern euro-zone banks, they said, with Spanish and Italian banks likely to be on the sidelines.

“After speaking with the banks, we think domestic Spanish banks – and others – may wish to keep the LTRO funds both as a cheaper source of funding and a useful insurance policy against sovereign uncertainties,” they said.

The appeal of an LTRO-unsecured swap

UniCredit analysts suggest that there is more to consider than the difference in cost of borrowing under the LTRO and in the market when weighing up the prospects of public market funding replacing LTRO funds.

For example, issuers might be deterred from issuing a two year covered bond because of rating constraints, they say, or because such a move could cannibalise capacity for longer dated issuance.

Plus, covered bonds are not the only game in town, as a resurgence of senior unsecured funding in the latter half of this year has shown, and UniCredit’s analysts say that those issuers that are theoretically willing and able to return LTRO money may see benefits in opting for unsecured debt over covered bonds.

“We value quite highly the exchange of unsecured funding versus secured funding and therefore would also accept a slightly higher all-in funding cost which brings the benefit of regaining backstop-liquidity,” they say. “In any case, however, this means that in order to exchange LTRO with covered bonds – an exercise which does not bring the additional backstop-liquidity benefit – one needs to have a much higher cost benefit.”