Despite covered bond spreads being at their equal tightest since September 2008 and concerns over peripheral fundamentals, analysts remain bullish about the prospects for higher yielding jurisdictions going into year-end.

According to Maureen Schuller, head of covered bond strategy at ING, the iBoxx Euro Covered index tightened 8bp to 57bp in October, and is now quoted at the tightest level since briefly touching this level in November 2009.

“Before that, we have to back to September 2008, i.e. the month after the fall of Lehman Brothers, for the last time we saw similar spread levels,” she said today (Friday).

Although having an underweight for Irish, Italian and Portuguese covered bonds in country allocation suggestions, Schuller remained strategically overweight such paper in research today (Friday). She noted that despite covered bonds from distressed jurisdictions having shown the strongest performance year to date, they still trade significantly wider than pre-Lehman Brothers spread levels, particularly multi-cédulas.

“The search for yield has proven to be a dominant spread driver for the covered bonds from these European jurisdictions,” she said. “However, we think the end-of-year rally will be less strong than in the past month considering the still challenging fundamental backdrop in the Southern European jurisdictions and lower support from coupon and redemption payments compared to September and October.

Analysts at DZ Bank switched to a “more offensive” investment strategy after the US shutdown was ended, on 22 October recommending overweighting high yielding peripheral covered bonds, and yesterday (Thursday) they noted that this had already paid off, with these jurisdictions outperforming the market average.

Last two weeks’ swap spread change by national segments (basis points)

Source: Markit, DZ Bank

“We see a relatively high probability that the recent weeks‘ spreads trend will continue through to the year-end,” said Günther Scheppler, covered bond analyst at DZ. “Now that political risk has reduced significantly in the USA, Italy and Germany and the talks between the troika and Portugal have come to a positive conclusion, the remaining residual risks to the market are now more moderate.

“While the covered bond market’s inherent risk potential has reduced significantly in the last few weeks, the now months-old excess of demand over supply remains in place,” he added. “We see little chance of this demand overhang eroding by the year-end.”

Natixis analysts echoed this view, despite noting that October has been the second busiest month this year for supply, with Eu10.6bn of euro benchmarks.

“With Eu10.3bn of covered bonds redeeming until year-end (Eu5bn in November, Eu5.26bn in December) compared to only maximum Eu10bn additional issuance expected by year-end, the covered bond market will continue to be driven by technical, which will be supportive of spreads,” they said.