Covered bond issuance was down almost 50% in the first quarter of 2013 in comparison with the same period in 2012, and analysts say factors including deleveraging, asset encumbrance concerns, and availability of central bank funding will combine to keep issuance volumes low for the rest of the year.

Issuance of new euro covered bond benchmarks fell from Eu54bn in Q1 2012 to Eu29.1bn in Q1 2013, according to data from DZ Bank analysts.

Covered bond issuance in recent months has been hindered by factors such as turbulence in the euro-zone following inconclusive Italian elections and the Cyprus bail-out. However, analysts say the trend of low primary market activity will continue for the rest of the year on the back of some structural factors, and that some estimates for full-year supply are increasingly unlikely to be realised.

“Our forecast of Eu110bn new euro benchmark issuance was already a modest estimate, just below last year, when the ECB’s LTROs contributed to an almost Eu80bn decline in euro benchmark issuance in comparison to 2011,” says Maureen Schuller, head of covered bond strategy at ING. “If issuance remains as it has been during the past two months, even that Eu110bn will be difficult to achieve.”

Analysts note several reasons for the low issuance volume.

Bernd Volk, head of covered bond research at Deutsche Bank, says that a major factor contributing to the low level of supply is that new lending remains low in most countries and central bank involvement remains elevated.

The availability of cheap central bank funding, many issuers going through restructuring and low new lending have pushed issuers away from the capital markets, leading to a decline in covered bond issuance.

“Bank funding is a politically and central bank dominated market,” says Volk. “With central banks and regulators growing also in terms of staff, this is unlikely to change any time soon.”

Another reason for low supply, says ING’s Schuller, is that banks and regulators in Europe are increasingly concerned about asset encumbrance, and this has been shifting capital market funding towards senior unsecured issuance.

Jörg Homey, covered bond analyst at DZ Bank, says this was exemplified in a recent European Banking Authority paper, which identified covered bonds as one of the main source of asset encumbrance, and is also shown by the progressive imposition of issuance limits.

“Although issuance limits are not common in all European countries, they are starting to become more common, see for example in Belgium,” he says. “In this context, unsecured bonds become more attractive for banks as an alternative to covered bonds as they can spare cover pool assets.”

The Belgian government set an 8% cap on the proportion of a bank’s assets that can be encumbered through covered bond issuance.

Banks in Europe are also progressively reducing the size of their balance sheets, adds Homey, and consequently have reduced funding needs.

Another reason for the low issuance, according to analysts, is a fall in house prices, especially in peripheral markets, which is putting pressure on LTVs and collateral availability as a result.

“Fewer new loans are originated against the background of turning housing price cycles in many European countries including France or the Netherlands, and depressed housing markets for example in Ireland or Spain,” says Homey.

Concerns about asset encumbrance and declining collateral availability are pushing issuers to prefer senior unsecured to meet their modest funding needs, say analysts.

According to Deutsche’s Volk, senior unsecured issuance is still attractive for stronger banks. He expects the volume of new senior unsecured debt to be higher than the volume of new secured debt in the rest of the year, also supported by asset encumbrance remaining in political focus.

Schuller says that the preference for senior unsecured issuance is evident in some jurisdictions like France.

“However, historical data shows that senior unsecured issuance is also at low levels,” she adds.

According to data cited by ING, euro senior unsecured issuance in the first three months of 2013 amounted to Eu59.3bn, which is almost half of what was issued in the same period in 2012, Eu117.2bn.

In combination with other factors, the limited covered bond supply of recent months has led covered bond levels to remain stable or to tighten slightly, in contrast with the larger volatility observed in senior unsecured and sovereign spreads following the Cyprus story, according to Schuller.

“Redemption and coupon payments have been very supportive of spreads against the background of hardly any issuance,” she says.

Low yield levels are set to persist, say analysts.

“Although the risk of spread widening remains as a result of the ongoing sovereign crisis in Europe, the swap spreads of covered bonds remain tight and they are currently still tightening step by step,” says DZ’s Homey.

Despite the spread tightening, analysts see the factors hindering covered bond issuance –namely central bank funding availability, concerns over asset encumbrance, and declining asset generation – as continuing to drive issuers away from the secured debt market for the rest of the year.

“Why would issuers want to tap the capital market when there is the alternative of cheap central bank funding?” asks Volk. “Core issuers don’t need to issue because of their reduced funding needs.

“Peripherals, especially Italian and Spanish issuers, should be the most interested in new covered bond issuance because of the large amount of bonds they retain, but they don’t want to pay high yields and they will continue to prefer central bank funding. This is all pointing towards low issuance for the rest of the year.”

Other analysts have a slightly more optimistic view. Homey says that issuers will return to the covered bond market during the course of the year.

“However, total issuance volume of euro benchmarks will most likely be below Eu100bn,” he says. “A number of around Eu90bn seems more likely, with lower issuance from some traditionally active issuers such as French, Scandinavian, Dutch and UK contributing to the subdued level of primary activity.”