The US dollar and sterling covered bond markets were unable to continue their expansion this year, as issuance fell in each. Analysts expect dollar supply to be steady in 2017, dependent upon arbitrage, and sterling to decline further, undermined by the BoE’s Term Funding Scheme.

Some $16.15bn (Eu15.43bn) of US dollar-denominated benchmark covered bonds have been issued this year. This compares with $21.6bn in 2015 and is substantially below estimates made at the end of last year, when analysts expected $25bn-$26bn of 2016 supply. With analysts citing redemptions in the range of $27bn to $31bn 2016, this also meant net negative supply of up to $14.85bn.

Issuance has also declined in the sterling market, with issuers having sold £5.95bn (Eu7.1bn) of sterling-denominated benchmark covered bonds year-to-date, down from £7.875bn last year. This translates to net positive issuance of around £4bn, according to analysts.

“Last year, other covered bond currencies – namely US dollar and sterling – significantly gained in importance, with primary market issuance in both currencies considerably exceeding 2014 volumes,” said Frank Will, global head of covered bond research at HSBC. “While both currencies remain important funding alternatives, the pace of supply has slowed a bit.”

The declining issuance in both currencies is attributed partly to Eurozone issuers preferring to issue in their domestic currency given the ECB’s covered bond purchase programme, and Will noted that with the exception of five German issuers, which contributed $2.7bn and £125m, all of this year’s dollar and sterling supply came from non-CBPP3 eligible issuers.

Analysts said the development of cross-currency basis-swaps also meant that euro issuance was the most attractive prospect for issuers from many jurisdictions at times this year – although opportunities did emerge for some issuers to print short-dated US dollar benchmarks inside achievable euro levels.

In the sterling market, the fall in issuance is attributed to uncertainty following the Brexit vote and to the Bank of England’s related Term Funding Scheme (TFS), which was announced in August and allows banks to borrow reserves in exchange for eligible collateral until at least 28 February 2018, reducing the funding needs of the UK issuers.

Dollar dynamics debated

In the dollar market, Will forecasts benchmark supply of $15bn-$20bn next year, while Michael Spies, covered bond and SSA strategist at Citi, expects $18bn.

Issuance is seen as being driven partly by high redemptions – of $30bn-$35bn – whole some analysts also anticipate a development of the cross-currency basis-swap that will make dollar issuance more attractive.

At times this year, favourable developments in the basis-swap made short dated dollar-denominated the most appealing prospect in covered bonds for many issuers, including those from Canada, Australia and Germany.

“In the US, central bank policy will probably continue to withdraw easing measures,” said Spies. “In fact, after the Trump win this year, a faster than initially expected path of rate hikes could be on the cards which could make the euro/US dollar cross currency basis swap fall further.

“This should favour US dollar benchmark issuance. And yet, the effect should generally be limited to non-EA [euro area] issuers which are more actively making use of the dynamics in cross-currency basis moves than EA issuers while very negative short end yield levels could still make German issuers to opt for front-end dollar issuance.”

However, some expect the competitiveness of dollars to deteriorate.

“Our rates strategists expect the euro/US dollar basis to move into less negative territory in 2017,” said Florian Eichert, head of covered bond and SSA research at Crédit Agricole. “Consequently the funding arbitrage will work less in favour of dollar issuance and we expect a focus on euros.”

Another factor that worked in favour of the dollar option this year, which was cited by many issuers, was a negative and low yield environment in euros that meant many jurisdictions could only access the short end if they printed negative yielding, zero coupon trades. Ultimately, many opted instead for dollars, which they said offered easier execution in the three to five year part of the curve.

Following a recent back-up in yields, issuers have once again enter the short end in euros, and with yields expected to move higher, analysts said some issuers may return to euros, where demand is deeper.

Expected growth in the Singaporean and South Korean markets could mitigate such moves, with Asian issuers having sometimes favoured US dollars. However, Singapore’s United Overseas Bank chose euros for its first covered bond, a Eu500m five year sold in March, and Oversea-Chinese Banking Corporation is expected to do likewise next year.

Canadian issuers are expected to lead the way in dollar supply next year, followed by Australian issuers, with the two jurisdictions to record the highest and second highest redemptions, respectively.

“All in all, redemptions will be recorded in 10 different covered bond segments,” noted Spies. “However, in five segments, the bond redemptions will mean that there won’t be any outstanding covered bonds left.

“That’s the case for France, Luxembourg, Spain, Switzerland and the United Kingdom. In case of Luxembourg and Switzerland new supply is very unlikely and we are also not overly optimistic on a near-term comeback of French, Spanish and UK banks to the US dollar market.”

BoE dampens sterling

In the sterling market, Spies expects £4bn of benchmark supply next year (including FRNs and issues of £250m). HSBC analysts have not given an exact forecast, but also expect lower issuance than this year’s £5.95bn. Unlike this year, such volumes would result in net negative supply, with analysts citing sterling redemptions of around £7bn.

The shortfall is expected as domestic issuers are likely to remain unenthusiastic about issuance while the Bank of England’s TFS remains operational.

“With the UK’s EU membership referendum out of the way, volatility should continue to be low, making the sterling market more attractive for domestic and non-domestic issuers and investors,” said HSBC’s Will. “The TFS, however, will probably continue to dampen covered bond supply from the UK banks.”

Spies noted that more than 60% of next year’s sterling redemptions come from UK banks.

“This is followed by redemptions of Canadian banks,” he said. “In case of Denmark, one principal repayment is recorded.

“Should Danish banks opt not to return to the GBP benchmark market in 2017, the segment would disappear from the sterling market.”