It’s starting to happen more often again: final pricing spreads are ending up a significant distance from initial price thoughts, says Andreas Denger, senior portfolio manager at MEAG. In this opinion piece he asks if it is time for fixed spread-range guidance and use of spread limits by investors on orders.

It happens all too often that initial price thoughts (IPTs) are tightened to a final spread that bears no, or very little, relation to the starting point. The most recent example of this is a Royal Bank of Canada Eu2bn seven year covered bond of last week, where the re-offer spread ended up at 16bp over mid-swaps, after IPTs of the low 20s. Two days earlier UniCredit Bank Austria priced a Eu500m five year issue at 26bp over, following IPTs of the 30bp over area. The move in absolute terms – the number of basis points – doesn’t seem to be that high but looking at it as a percentage, the picture changes.

First, I need to make clear that this is not a complaint about final spreads being too tight, or specifically about the aforementioned deals. If an order book contains sufficient orders for a certain pricing spread, then that is fine. What is important is how we get to the final spread.

In my opinion, the initial spread guidance should show the range in which the issuer has committed itself to price the bond, and should not be a “best guess” approach to collect a huge amount of indications of interest. The initial spread guidance should be a sustainable and fixed range that investors can use to make a general decision about whether or not to participate in a deal, and for creating possible relative value trades. As this process clearly costs valuable time, I hope that it is understandable that one is not happy to see the initial spread guidance wiped out by much tighter final spreads that destroy at least some of the generated trade ideas.

I can fully understand that finding the right spread (initial spread range) is not always easy. If it is not easy to figure out how much demand a new issue will generate and/or where the right spread would be, go out and do a roadshow to collect investor feedback. Together with the volume an issuer is willing to issue, this should enable banks to set a sustainable initial spread guidance range within which the bond can be priced.

I can also understand that banks like to show the issuer that they managed to price the deal at tighter levels than those initially announced while still building a great order book. The deal is then called a blow-out and a great success, and sometimes this is even true despite a very poor bookbuilding process that seems to be forgotten much too quickly by the leads and the issuer.

However, banks and issuers should not risk losing the willingness of many investors to provide feedback ahead of a deal or to offer some sort of commitment. Poor bookbuilding (when the final spread bears no relation to the level that the feedback was about), leaves a bad taste in the mouth. Compared with some other market participants, at least some investors do remember bookbuilding procedures.

I can understand some banks arguing that allocations will be a nightmare if they do not tighten the spread, but then perhaps they shouldn’t attract so many orders by starting the deal with promising IPTs. As most investors place their orders without setting a spread target, I don’t know how much smaller the orderbook really gets by tightening the spread (I’m talking about real interest orders, i.e. taking out inflated orders which might get reduced after the spread gets lowered). If a bond is sold out, it’s sold out. Close the book and leave the spread within the spread range.

I accept that investors not assigning a spread target to their order is something that cannot be overlooked when talking about bookbuilding problems for new issues. By omitting to limit their orders, do investors hope to get a better allocation or do they just not know where the bond should price? If so, I believe even more responsibility lies in the hands of the leads and the issuers to start with the right initial spread guidance and stay within this range. A sustainable and fixed spread guidance is maybe more necessary than ever.

I hope to see more new deals coming to the market with a sustainable and fixed spread range, as opposed to within a certain spread area. And on the other hand I would like to see more investors assigning a spread limit to their orders. Don’t start at the lowest end of the spread range if your estimated fair price is higher. If it turns out during the bookbuilding process that the final spread will be at the lower end of the fixed range, you can still decide whether you want to set your limit lower or take out the order before the book closes. As you know from the beginning in which spread range the bond will price, you can use this to express your views.

If banks tell investors not to set a limit or only a very low one because this might hurt their allocation, then this does not demonstrate very good market behavior in my view.

If you would like to discuss contributing an opinion piece to The Covered Bond Report, please e-mail Neil Day, nday@coveredbondreport.com or call on +44 20 7428 9575. We are keen to hear well-argued opinions addressing topical themes in either a positive or negative light. Also, feel free to share any thoughts on the above using the comment function below.