Covered bonds enjoy regulatory tailwinds heading into 2014, but the benchmark market is nevertheless expected to shrink. Performance could be affected by wildcards ranging from LCRs to LTROs, AQRs to SMEs, and peripherals to pass-throughs. Neil Day picks out the essentials.

The bets are in! And covered bond analysts have put their money (metaphorically speaking, of course — not wanting to get anyone into trouble) on euro benchmark issuance ranging from Eu100bn-Eu120bn in 2014.

While even the lower end of this range would represent growth on issuance just shy of Eu100bn in 2013, most analysts have higlighted that this would represent a net shrinkage of outstandings by some Eu50bn.

Barclays analysts, for example, note that 2013 marks the first year in which the benchmark covered bond market has shrank, putting the decline in outstandings at Eu55bn based on supply of Eu111.5bn ($153bn) (across currencies) to mid-November, when their 2014 outlook was published. They cite three reasons why this fall has occurred after covered bond growth over the previous decade that was fuelled by being the only funding game in town during the crisis and regulatory and political support for the product.

“First, the ECB’s liquidity injection, in the form of two three year LTROs in December 2011 and February 2012, reduced market funding needs for many covered bond issuers and this impact lasted well into 2013,” say Barclays analysts. “Second, banks are under increasing pressure to reduce leverage and shrink their balance sheets. In particular, most covered bond issuers that also expanded into public sector lending remained under pressure to reduce their portfolios.

“Third, mortgage production slowed in many jurisdictions in 2013, reducing covered bond collateral production and, thus, funding needs.”

And they expect these factors to continue to be in play in 2014.

Indeed UniCredit analysts believe any European Central Bank liquidity injections to be so important that they have given two forecasts dependent upon whether or not the ECB holds a third LTRO and, following their economist colleagues’ conclusions, their base case incorporates such central bank action. Their forecast for gross supply in this scenario is Eu100bn, rising to Eu121bn in the absence of a new LTRO, with the timing of any LTRO determining just where between these two figures issuance might end up.

“The sharp drop of gross issuance levels of 2012 vs. 2011 demonstrates the potential degree of impact central bank action has,” they say.

Peripheral jurisdictions would be most affected by a new LTRO under UniCredit’s analysis, with Portuguese issuance, for example, rising from zero to Eu2bn in the absence of an LTRO, supply from Italy doubling and from Spain rising by 50%.

UniCredit analysts say, in line with their economist colleagues, that ECB actions will be more targeted towards those in need and towards the real economy than previously, and Barclays analysts also believe that “the stigma attached with high level of central bank funding has increased, especially in light of the upcoming ECB asset quality review (AQR) and balance sheet assessment”. They believe that central banks’ corralling of banks towards capital markets funding combined with lower market funding costs than last year will support covered bond issuance in 2014.

However, they note that, with senior unsecured a viable option, covered bond funding may be saved for a rainy day. Joost Beaumont, fixed income strategist at ABN Amro, highlights how this was already a trend in 2013.

“Although bank funding needs have diminished due to weak economic conditions and bank deleveraging, the drop in covered bond funding has been more profound than that of senior unsecured funding,” he says. “One of the main reasons is that spreads of senior unsecured paper have come in more sharply than those of covered bonds.

“Another reason is that unsecured funding has the additional advantage that it does not result in asset encumbrance. So from an issuer’s perspective, it has become more attractive to issue senior unsecured bonds rather than covered bonds.”

However, Beaumont expects the performance of senior unsecured versus covered bonds to moderate and reverse as regulatory considerations become a more important factor relative to market sentiment.

“We expect that covered bonds will regain ground versus senior unsecured paper, as regulation is moving into a direction that favours covered bonds over unsecured paper,” he says. “What’s more, it seems that the narrowing of the spread differential between senior unsecured paper and covered bonds has been mainly driven by improving market sentiment, dominating indications of regulatory changes.

“We think that the current trend could well continue, but that once regulatory issues become clear, this will become a driving force of the covered versus the senior unsecured market. As a result, covered bonds will become a more attractive investment than senior unsecured paper.”

The two key regulatory drivers identified by Beaumont are bail-in under the Bank Recovery & Resolution Directive and the treatment of covered bonds in Liquidity Coverage Ratios (LCRs), which is due to be decided by the European Commission in June 2014.

A surprise move by the European Banking Authority to potentially exclude covered bonds from Level 1 status (see Monitor: Legislation & Regulation for more) came in the middle of analysts’ forecasts.

However, while LCR treatment is undoubtedly a key question for the asset class, some analysts play down its potential spread impact. DZ Bank analysts, for example, expect any impact — whether negative or positive — to be only moderate, since it only affects bank investors.

But Maureen Schuller, head of covered bond strategy at ING, highlights how LCR regulations could have an impact within the asset class. Alongside the question of whether covered bonds should be Level 1 or Level 2 assets, the EU authorities also face the contentious issue of whether or not to have a ratings threshold for eligibility, with a AA- cut-off point having initially been proposed by the Basel Committee on Banking Supervision.

“A distinction within covered bonds, either by ratings or on the basis of other criteria such as transparency, may become the key driver to spreads for markets already believed to trade very tight,” says Schuller.

Although peripheral covered bonds, being lower rated, are those that would most probably be negatively affected by such a distinction, there is a consensus among analysts that such issuance is overall the most likely to perform in 2014.

This would be a continuation of the 2013 trend. BayernLB analysts note that covered bonds from the EU periphery offered the best potential returns by far over the past 12 months — as indeed they had in 2012.

“Based on the iBoxx Covered Spain, Spanish cédulas generated a return of 11.9% (2012 11.6%), which is all the more impressive when one considers the current low interest rates,” they say. “Similarly, Portuguese and Italian covered bonds also generated returns far above average (8.6% and 4.9%, respectively) while covered bonds from Europe’s core posted an inflation adjusted real loss of over 1%.”

This compares with an average covered bond return of 4%, as measured by the iBoxx Covered All.

“Investors’ quest for returns has certainly been a boon to many covered bond segments in recent months,” continue the BayernLB analysts, “particularly those in the EU periphery. We expect this to continue to be the case in 2014 — due in large part to persistently low interest rates. That is because EU periphery covered bonds are the only segments offering average returns considerably higher than 2% and therefore beating inflation with a relatively short duration.

“Moreover, while the spread carry already argues for the periphery, we would not rule out that the flood of liquidity might also lead to further spread tightening in those segments, even though sentiment is likely to be burdened at times next year.”

Like their peers, DZ Bank analysts recommend an overweight position in peripheral covered bonds and also seek to identify those factors that might “burden” the market — “stumbling blocks”, in their words. While bullish overall, they acknowledge that there is a good chance that the tightening trend of 2013 could turn much more volatile, given “a series of exceptional factors” capable of triggering spread widening (see chart).

Prominent among these is the looming asset quality review.

“Out of all the events that have the potential to trigger broad-based widening of covered bond spreads next year, we believe that the asset quality reviews and balance sheet stress tests of the major European banks that the ECB and EBA will jointly perform next year present the biggest threat,” said DZ’s analysts. “The EBA has already warned that its stress test is going to be much tougher than previous tests. The ECB says it is inclined to publish no results at all until ‘back-stop solutions’ are in place, i.e. ways of financing capital-needy banks.

“Our base scenario assumes that no advance information will leak into the public arena ahead of the official announcement of the results and that back-stop solutions for strengthening capital-needy banks will be unveiled at the same time as the results are released. If our base scenario proves to be accurate, large scale spread widening should not occur.”

However, they note that risks remain, while Barclays analysts also offer advice for investors wanting to position themselves to guard against headline risk from the stress-testing.

“To limit this risk, we would focus more on names not subject to the stress testing directly,” they say. “i.e. covered bonds from non-EU countries, SSAs not subject to the stress test.”

Meanwhile, if several of the stumbling blocks identified by DZ Bank combine and coincide with the ECB signalling a tightening to produce the analysts’ worst-case scenario, the covered bond market would be at risk of “extreme spread widening”, they say.

“The recommended strategy in this scenario is for investors to drastically increase the proportion of relatively safe covered bonds in their portfolio (say, by adding German or Scandinavian covered bank bonds).”

Moving targets

As The Covered Bond Report was going to press the US Federal Reserve began its long-awaited and at times feared “tapering” of its quantitative easing (QE) — something that market participants have been trying to factor into their forecasts. Initial reactions to the news chimed with BayernLB’s forecasts: “Thus, although the political environment is likely to weigh on sentiment in 2014, we expect the market’s reaction to the anticipated start of tapering will probably be less dramatic than it was in the summer of 2013. As a result, tapering is not likely to be a negative factor for the market. However, the market’s reaction will depend on the economic situation and market sentiment at the time that the tapering decision is made. After a first failed attempt, we expect the Fed to hold off on taking another stab at tapering until the economic situation in the United States is secure, in particular until employment figures rise substantially.”

The risks arising from tapering are nevertheless considered as a factor that could support euro issuance versus dollar issuance, according to Bank of America Merrill Lynch analysts.

“Any impact from the tapering in the US would likely be more stressed for US dollar covered bond spreads than for euro core covered bonds, which might further discourage European banks from tapping the market,” they say.

“The US dollar covered bond market has shown softer market technicals,” they add. “That said, as redemptions start picking up from 2014, this might change if gross issuance remains limited. Canada and Australia continue to be the main growth drivers for the market.”

They expect $30bn-$35bn of gross issuance in 2014, translating into net issuance of around $15bn-$20bn given redemptions of some $15bn. Two other factors play into their forecast: “Increased FX diversification in favour of the euro market based on the evolution of cross-currency basis swaps — especially for Canadian banks which are expected to launch more of their new ‘registered’ covered bond programmes.” And: “The strongest European banks (especially Nordics) are likely to remain the main drivers for US dollar issuance as the market is not necessarily attractive for banks still suffering from a stigma due to the European sovereign crisis — particularly as there is less need for diversification due to lower issuance volumes.”

A similar US picture is painted by Citi analysts.

“For the US dollar covered bond market, we expect an increase in issuance given the finalisation of the Canadian covered bond law and the usage of the US dollar market by Australian covered bond issuers,” they say. “We forecast US dollar covered bond issuance to total $30bn in 2014, mainly from Canadian, Australian and Norwegian covered bond issuers.”

One factor that is expected to remain notable only by its absence in 2014 is US covered bond issuance.

“There has been no real progress made to establish a legal framework for covered bonds in the US,” note Natixis analysts. “In addition, in October 2013 the Fed proposed its Liquidity Coverage Ratio (LCR) which appears more stringent and includes a narrower range of assets than what the Basel Committee has proposed.

“Covered bonds are excluded from the proposal, leading us to believe US covered bonds are not a priority.”

Changing priorities for the UK authorities made sterling and UK covered bond forecasts a moving target for analysts. RBS, for example, published their outlook for UK covered bond supply in a research note on the morning of 28 November, only to have the Bank of England and Prudential Regulation Authority announce later that day that it would not be extending the mortgage part of the Funding for Lending Scheme (FLS) — a key factor in recent UK covered bond volumes and forecasts.

However, the announcement was not expected to merit a major revision to UK supply forecasts, which have typically put UK euro benchmark covered bond supply at between Eu2bn and Eu4bn — although Citi analysts are forecasting a more bullish £5bn (Eu5.93bn, $8.16bn) of sterling covered bond issuance from UK banks in 2014.

Forlorn hope?

Growth years in the covered bond market have typically been characterised by the ramping up of issuance in young jurisdictions — particularly those with large wholesale funding needs — or the opening of new markets. But with all European Union markets having come on stream by the end of last year (with the arrival of Belgium) and other major economies (such as Australia and Canada) already present, 2014 is not expected to benefit thus.

UniCredit analysts nevertheless hold out some, possibly forlorn, hope on this front.

“The list of names that are rumoured to be on the verge of appearing in euro benchmark format includes Turkey, Singapore, Korea and — running gag — the US,” they say. “If two out of these four succeeded in closing a euro transaction we would talk of an enormous success.”

If novelty does boost the market in 2014, it appears just as likely to be from new types of covered bonds as new jurisdictions. After all, although representing only one deal each, a Commerzbank SME-backed structured covered bond and a NIBC conditional pass-through issue made 2013 a banner year for innovation.

“Other banks are likely to follow the lead of NIBC Bank and Commerzbank by offering new types of transactions, such as SME covered bonds and pass-through structures,” say NordLB analysts, who expect such deal types to give new impetus to the market.

Barclays analysts are, however, more sceptical on the SME front.

“The promotion of SME lending is high on the agenda of European authorities,” they say. “The development of funding tools, including SME-backed covered bonds, is one area authorities seem to be keen to explore. Banks may adhere to this policy objective, embrace the idea and explore the demand for SME-backed covered bonds.

“At this stage, we do not expect strong growth of this segment, as it seems that authorities prefer to use securitisation technology to achieve their respective policy goals.”