A new Term Funding Scheme announced by the Bank of England yesterday (Thursday) will lead to a fall in UK covered bond issuance, according to bankers, and along with other measures will support a further tightening of sterling spreads and a retracing of recent underperformance.

The Bank of England yesterday announced a package of measures in response to a weakening in the outlook for the UK and a fall in the value sterling, in the wake of the UK’s vote to leave the EU. These measures are:

• a 25 basis point cut in the bank rate to 0.25%;

• a new Term Funding Scheme that will provide funding for banks at interest rates close to the bank rate;

• the purchase of up to £10bn (Eu11.9bn) of UK corporate bonds over an initial period of 18 months;

• and an expansion of the asset purchase scheme for UK government bonds of £60bn, taking the total stock of Gilt purchases to £435bn.

The central bank said that under the corporate bond purchase scheme (CBPS), it will buy sterling bonds issued by companies – including their finance subsidiaries – that make “a material contribution to economic activity in the UK”. Corporate bonds issued by banks, building societies and insurance companies will not be eligible, with covered bonds therefore ineligible.

The Bank of England said the new Term Funding Scheme (TFS) will allow participants to borrow reserves in exchange for eligible collateral from 19 September to at least 28 February 2018. The central bank will charge interest on the transactions equal to the bank rate plus a scheme fee, which will range between 0bp to 25bp per year depending on the bank’s net lending, and each transaction will be four years. Applications to join the scheme can be made from 22 August.

Bankers said the scale of the new measures surprised the market, with many participants expecting only a rate cut, and they noted that 10 year Gilt yields dropped more than 15bp to a record low of 0.64% yesterday afternoon.

Analysts said they expect yields and spreads to fall further over the coming weeks as markets price in a potential expansion of the newly announced QE, or the possibility of another rate cut, as a majority of Monetary Policy Committee (MPC) members say they expect to support a further cut in the rate “to its effective lower bound” at one of the MPC’s meetings later this year. The MPC said it considers this bound to be close to, but a little above, zero.

Spreads of sterling covered bonds meanwhile tightened 3bp-5bp across the curve and across jurisdictions, according to syndicate officials, while some marginal tightening was also seen in the euro spreads of UK issuers.

“That’s a function of two things,” said a syndicate official. “In part it’s simply because sterling market feels more positive across all asset classes, given yesterday’s measures.

“But it’s also down to the expectation that with that Term Funding Scheme you will see less supply in funding markets from the UK banks, outside of strategic HoldCo senior, and so on.”

The syndicate official noted that Barclays was in the market with a sterling-denominated HoldCo issue today.

“That anticipated trend is already bearing out,” he said.

Bankers said that the TFS looks attractive to issuers, and noted that when the Bank of England launched a similar Funding for Lending Scheme (FLS) in 2012 UK covered bond issuance fell, while the launch of a new series of targeted longer term refinancing operations (TLTROs) by the ECB had a similar impact on Eurozone supply this summer.

“Given the behaviour pattern that we saw with the FLS, we should be anticipating less supply from the UK banks overall,” said a syndicate official.

An analyst agreed that UK bank’s lower funding needs will translate to a lack of covered bond supply, both in sterling and in other currencies.

“On one hand its bad news for investors, because there will be less supply,” he said. “But on the other hand this should be beneficial for the spread performance of UK covered bonds.”

Florian Eichert, head of covered bond and SSA research at Crédit Agricole, cut his forecast for euro-denominated UK covered bond issuance for the remainder of the year from Eu3.5bn (based on an initial Eu9bn full-year 2016 forecast and Eu5.5bn of issuance year-to-date) to Eu1bn-Eu2bn – “in essence, one or two opportunistic long-dated benchmarks.”

Bankers said the new measures will also likely support further tightening in the sterling covered bond market, but disagreed as to whether such lower spreads will increase non-domestic issuers’ interest in the currency.

“With sterling looking relatively less unattractive than dollars or euros than it has historically, I perhaps would expect a slightly higher proportion of any funding to be executed in that market, maybe leading to a slight increase in sterling covered bond supply,” said a syndicate official.

“I think that as you see spreads tighten and sterling products outperform – or at least retrace the underperformance they have had versus other currencies – that should encourage international issuers to look into the sterling market as well.”

However, another syndicate official said that recent issuance volumes demonstrate that sterling issuance is substantially less cost-effective than the alternatives for most issuers.

“If you want to do a three year and you’re a UK bank or maybe an Aussie, then it makes sense, but other banks will continue to look elsewhere,” he said. “Even with the tightening since yesterday, the pricing is still hard to justify for other international issuers.”

The syndicate official said, for example, that a new sterling benchmark priced at three month Libor plus 40bp, which he said would be an aggressive level, would be equivalent to around 60bp over US dollar Libor. He noted that Germany’s BayernLB priced a three year $300m issue at 45bp on Tuesday.

“There’s definite upside for the sterling market, but I think spreads still have a long way to go,” said the syndicate official.

An analyst also suggested that international issuers had also been cautious about tapping the sterling market, given uncertainty surrounding Brexit and its impact on the market.

“If you take a look at who has been active in the sterling market, there are of course the UK names and then the Canadians, Norway, Sweden, and then maybe the odd German,” he said. “What we have seen in the past is that if you get some domestic issuance, then the non-UK houses jump on the bandwagon.

“But I can’t see that the Canadians and the Nordics will come to the market and take this opportunity on their own.”

Santander UK reopened the sterling covered bond market in the wake of the Brexit referendum with a £500m three year FRN on 1 July, before Canadian Imperial Bank of Commerce then followed a week later on 8 July to double in size a £250m (C$419m) May 2019 FRN.

Photo: BoE governor Mark Carney; Source: Bank of England