The risks associated with a UK referendum on leaving the EU are not yet priced in to UK covered bonds, according to some market participants, ahead of a key summit next week and with opinion polls increasingly showing a majority in favour of leaving.

UK prime minister David Cameron is hoping to finalise a package of reforms of the country’s relationship with the EU at a summit starting next Thursday, ahead of a referendum as early as June on whether the UK should remain in or leave the EU (with the latter dubbed “Brexit”).

In recent research BAML analysts pointed out that analysing the threat of Brexit is difficult because not only does it entail considering the chances of the UK leaving the EU, but further the unanswered question of how Brexit would occur.

“The only certainty is the uncertainty this process – if and when it takes places – creates,” they said.

The BAML analysts looked at the potential impact of Brexit on the UK residential mortgage market – a key factor for covered bond credit quality – based on considerations about the possible impact on the UK economy and capital markets, and taking into account measures that could be taken by the UK government and Bank of England.

The BAML analysts stressed that formulating economic scenarios regarding the impact of Brexit on UK GDP is difficult, but outlined four scenarios ranging from a positive impact with a 1%-2% boost to economic activity, to a severe economic contraction (4%-6%) and other negative consequences including a 20%-30% fall in house prices that remain depressed in the medium to longer term.

Even considering the impact of the latter scenario based on an examination of historical precedents such as the early 1990s and late 2000s, the credit effect of a potential Brexit on UK covered bonds – as for RMBS and CMBS – is “manageable”, according to Anne Caris, research analyst at Bank of America Merrill Lynch.

“But cover pools differences could translate into varying asset quality pressures – e.g., due to higher exposure to London and the South East, which tend to undergo deeper corrections and stronger recoveries,” she added. “That said, we believe all cover pools would be exposed to a sudden and material rise of interest rates which cannot be ruled out.

“Should credit risks deteriorate beyond our expectations, the UK covered bond legal framework would act as a quality safeguard, we think. Any breach of the legal minimum criteria would need to be remedied, while we are not concerned about the ability of UK banks to maintain the quality of their cover assets given their overall low level of encumbrance.”

She also highlighted the need to understand the consequences of headline risk for covered bonds resulting from any stress at the bank level, as witnessed recently in Italy.

According to Caris, Brexit risk is not priced in for UK covered bonds.

“We remain cautious on UK euro covered bonds given the uncertainty around Brexit, with polls still too close to call,” she said. “ASW spreads still trade tightly versus other non-European issuers and do not reflect macro/headline risks or a possible weaker treatment under EU regulation for investors should the UK leave.”

Jörg Homey, head of covered bond research at DZ Bank, has also noted that Brexit is not priced in to UK covered bonds, even if they have widened in line with the market. However, in spite of the looming risks of Brexit, and noting that CBPP3 is driving the market, he has maintained a neutral recommendation for UK covered bonds within iBoxx Euro Covered indices.

“We assume that the swap spread of UK covered bonds will continue to move in line with the general market trend in the next few weeks,” said Homey. “The spread differentiation between individual issuers is likely to remain small.

“For this reason, in the case of new positions and all else being equal, it would make sense from our point of view to opt for bonds from UK banks with a strong rating when entering new positions.”

A DCM official noted that UK supply this year has been comfortably absorbed – Lloyds drew more than Eu2bn of demand for a Eu1.5bn (£1.17bn) five year benchmark on 11 January and Abbey Eu1.3bn for a Eu1bn long five year on 1 February. He said the Abbey deal was sold to “the usual suspects”, and noted that European agencies in particular had been active in buying it.

“There doesn’t seem to be anybody on the investor side turning around and saying: ‘I’m not touching this paper because I’m worried about Brexit or I’m concerned about what David Cameron is getting out of Brussels.’ Far from it.

“It’s not something that’s come into play yet in the deals thus far this year, or in the deals we did last year, when Brexit was still very much on the agenda. It’s lurking in the background, but people don’t seem troubled by it, largely.”

According to Caris at BAML, UK issuers have “modest” covered bond redemptions of around £8bn equivalent in 2016, almost all in euros. She said that UK banks could reduce euro covered bond issuance should it become too expensive and tap the sterling market, taking advantage of their domestic investor base.

Photo: UK Independence Party (UKIP) leader Nigel Farage; Source: European Parliament