Covered bonds are virtually as liquid as government bonds, according to a “very preliminary” draft ranking released by the European Banking Authority yesterday (Wednesday), which market participants said puts the asset class in a strong position to be considered as Level 1 assets in Liquidity Coverage Ratios.

EBA offices, London

The regulator released its findings at a public hearing on liquidity in London, where it also summarised responses to a discussion paper on defining liquid assets released in February and its views on the feedback. The EBA is charged with advising the European Commission on the determination of “extremely high” and “high” quality liquid assets (HQLA) for LCRs under the Capital Requirements Regulation (CRR), corresponding to Level 1 and Level 2 assets under Basel III.

In the EBA’s preliminary ranking of liquidity levels across asset classes it ranked government bonds, covered bonds, non-financial corporate bonds, ABS (including RMBS) and equities according to eight criteria.

Covered bonds achieved exactly the same average ranking as government bonds, of 2.00, which put the two asset classes at the top of those measured. Covered bonds came highest in the categories of price impact, roll measure, return volatility and 30-day price change, while having their lowest ranking (fourth) in zero-trading days.

First very preliminary draft ranking on liquidity levels across asset classes (1 best position)

Source: EBA

Covered bonds were slightly behind government bonds, with an average ranking of 1.63 versus 1.50, when the EBA considered only debt instruments with credit quality ECAI 1. The asset class came out top in four categories and its worst position, again zero-trading days, was third.

First very preliminary draft ranking on liquidity levels across asset classes where only debt instruments
with credit quality ECAI 1 are included (1 best position)

Source: EBA

The ranking is based on, for bonds, MiFID data, for the period 1 January 2008 to 30 June 2012.

Ralf Grossmann, head of covered bond origination at Société Générale and chair of the European Covered Bond Council technical issues working group, described the EBA’s findings as “good news for covered bonds”.

“The EBA doesn’t draw any conclusion, but the obvious expectation is that covered bonds (at least those rated AA-) would be classified at Level 1 assets under the HQLA definition of LCR,” he said. “At that stage this is still speculation, but market discussions and lobbying will begin quickly.”

Frank Will, head of covered bond research and chair of the ECBC EU legislation working group, also said that the preliminary results looked positive, but noted that the EBA highlighted that differentiations within an asset class with regard to rating, issue size, maturity, repo-ability and other features are possible and could impact the final outcome. For example, the EBA had found that for covered bonds, as well as RMBS, there is a major difference between ECAI 1 and other credit steps.

“A special treatment of highly rated assets including covered bonds (i.e. rated double-A or higher) is problematic in our view as it would further increase the rating cliff issue and would also be against the public stated intention of the EU to reduce its reliance on external rating agencies,” said Will. “Furthermore, the EBA highlighted the importance of regulatory characteristics such as transparency as important features supporting the industry efforts in form of the covered bond label which aims at further improving the transparency of the covered bond product.

“Once the EBA has finalised its list of liquid assets,” he added, “we would expect that the European Commission will largely follow the EBA recommendation — though small changes cannot be ruled out. This could mean that some uncertainty about the final list of extremely high and high liquid assets will remain until mid-2014 when the delegated act must be adopted.”

The EBA presentation can be found here.