Euro benchmark covered bond supply in 2017 will at best match this year’s ultimately disappointing volumes, or even fall, analysts expect, with factors such as the emergence of new markets doing little to mitigate drags on issuance, while the spread outlook is mixed on uncertainty and ECB moves.

Estimates from 14 analysts range from Eu110bn-Eu130bn for next year, with most expecting euro benchmark supply in the region of Eu120bn-Eu125bn. This remains in line with some analysts’ early estimates published in November.

If such forecasts prove correct, next year’s issuance will probably be in line with or just short of this year’s volumes, as some Eu125.7bn of euro benchmark covered bonds have been issued year-to-date. The last euro benchmark issue came last Wednesday, and most market participants say the market is now closed until the New Year, leaving the 2016 total well short of the Eu145bn-Eu155bn forecast by most analysts at the end of last year – although BayernLB analysts were almost spot on with their forecast of Eu125bn.

Although analysts cite varied figures for 2017 redemptions, all agree that the volume of bonds maturing next year will be lower than the roughly Eu150bn that matured this year. All also expect net supply to be negative or at best roughly flat to redemptions.

Such lower redemptions are cited as a key driver of the anticipated fall in issuance next year, meaning, in conjunction with low – albeit recovering – mortgage lending and large net deposit inflows in some jurisdictions, that many issuers have lower funding needs.

“Banking system deposits continue to grow compared to assets,” said Agustín Martín, head of European credit research at BBVA, “particularly in the periphery such as Spain where the loan-to-deposit ratio has come down from around 137% in 2012 to around 111% at present, meaning that there is simply less need for balance sheet funding.”

Overall, such drags on issuance are widely expected to win out over more conducive factors.

“While the still relatively high volume of repayments of Eu120bn in 2017, and the continued support from the ECB under CBPP3 in fact speak for lively issuing activity, in our view the arguments for merely subdued primary activity next year prevail fairly clearly,” said Alfred Anner, senior covered bond analyst at BayernLB.

A major driver of the slump in issuance in the second half of this year was the ECB’s second series of targeted longer-term refinancing operations (TLTRO II), which commenced in June. The last of the four tranches will begin in March, and all have maturities of four years.

All of the analysts cited the TLTROs high among the factors that will dampen enthusiasm for covered bond issuance throughout next year. Frank Will, global head of covered bond research at HSBC, said the attractiveness of covered bond issuance has diminished further relative to the funding levels offered by the TLTROs following a recent back-up in yields.

“The TLTRO II is particularly attractive for issuers from non-core countries as they face higher new issue yield levels,” he said. “We therefore expect 2017 to be another year of low supply volumes from these countries.

“Moreover, the recent rise in yields has increased the relative attractiveness of the TLTRO for core country issuers.”

Michael Spies, covered bond and SSA strategist at Citi, agreed that TLTROs are a more tempting proposition than shorter dated covered bonds for many issuers, but said this could change as a result of a change to the parameters of the ECB’s QE programmes last week – when the central bank made securities with yields below its deposit facility rate of minus 0.40% eligible for purchase.

“The removal of the depo rate floor as a purchase limit under QE drove short term EGB yields lower,” he said. “Should covered bonds follow, covered bonds might be a more attractive funding option than TLTRO.”

In the UK the Bank of England’s 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, is expected to have a similar impact to the TLTROs.

“In general, UK banks do not have large funding needs and benefit from a high level of deposit funding,” said Will. “However, the levels of the TFS looks attractive compared with the current level achievable in the covered bond market, whether in sterling or euros.

“We would therefore expect new issuance activity by the UK covered bond issuers to slow in 2017.”

ECB lower but not out

The European Central Bank is expected to remain the most influential player in the covered bond market next year. On Thursday, it announced that it will continue its purchases under its asset purchase programme (APP) at the current pace of Eu80bn per month until the end of March, which had previously been the programme’s earliest end date, and then from April will continue to buy at least Eu60bn per month until at least the end of December 2017.

As CBPP3 is the longest running of the ECB’s open QE programmes and given central banks’ apparent difficulties in sourcing new covered bonds, market participants have speculated that covered bond purchases will be scaled back when the ECB’s target is lowered in April, with other programmes picking up more of the slack.

Although the extension of the programme was longer than many market participants expected, and despite many being surprised by the size of the continued purchases, the announcement did not prompt any of the analysts to revise their euro covered bond supply forecasts.

Analysts who cast their forecasts after the ECB’s decision estimated that as of April, the ECB will purchase around Eu3bn-Eu4bn of covered bonds per month.

“On the one hand, this would still mean that the ECB will report a year-end CBPP3 figure north of Eu250bn,” said Spies. “It would however also mean that the ECB will hold only around 30% of the Euro iBoxx covered bond index at the end of 2017, taking into account 2017 supply and redemptions.

“This is clearly lower than market participants’ forecasts on ECB CBPP3 holdings several months ago.”

The changes are expected to cause a widening of covered bond spreads and a further steepening of the spread curve.

“In our recent discussion with investors the one common theme was the market impact a tapering or even a complete stop to the CBPP3 purchases would have on covered bond spreads,” added Will. “We think the combination of lowering monthly volumes while extending the maturity of the programmes by another nine months limits the downside risks for the covered bond market.”

Analysts also noted that spreads between senior unsecured bonds and covered bonds are historically tight in some countries, suggesting that many issuers might prefer senior issuance over covered bond issuance next year.

“That said, 2017 promises to be a year full of macro risks which usually affect unsecured bonds more than low beta covered bonds,” said Citi’s Spies.

These macro risks – including but not limited to Brexit risks, political uncertainty and a troubled banking sector in Italy, and the march of populism across the Eurozone – are cited by many analysts as a challenge that all financial markets must face next year. Such headlines could periodically close the markets and complicate issuers’ funding plans, although covered bonds’ resilience in such times offer some hope.

“Market appreciation of the risk of political ‘populism’ has been heightened since the Brexit vote, Trump’s victory and most recently the Italian referendum,” said BBVA’s Martín. “Given that covered bonds are a ‘risk-off’ product, heightened risk premiums emanating from the French, German or Dutch 2017 elections could see an increased demand for covered bonds.”

Noobs welcome

Other rays of light in the forecasts include the potential of new issuers and new markets.

“The primary market, on the other hand, is likely to be slightly more buoyant due to new issuers,” said Christoph Anders, senior covered bond analyst at DZ Bank. “This year we counted 13 issuers that have approached the primary market via debut issues in the euro benchmark format, totalling Eu6.75bn.”

Including returning issuers such as Bank of New Zealand, who in June returned to the euro benchmark market for the first time in four years, Anders also cited the promise demonstrated by true debutants such as Poland’s PKO Bank Hipoteczny, Singapore’s United Overseas Bank and Denmark’s BRFkredit.

“We think the bulk of new issuers will be active again on the primary market in 2017, too,” said Anders. “We expect further supply from Poland and Singapore.”

The potential for substantial issuance from Turkey was cited by many, with VakıfBank having sold the country’s first benchmark this year and up to four other issuers said to be eyeing the market. However, issuance is expected to be dependent on a calming down of political risk in the country.

This year, German issuers have once again been the most active in the euro covered bond space, selling some Eu23.35bn of benchmarks supply year-to-date. France is second, with Eu20.85bn, followed by Spain with Eu13.25bn and Canada with Eu12.5bn.

Germany and France are expected to top the charts again in 2017, with Spain and Canada competing for the final spot on the podium, although some analysts expect France to overtake Germany next year, on the back of higher redemptions for French issuers.

“However, in all four cases, we pencil in lower primary market activity than volumes recorded in 2016, due to several reasons,” said Citi’s Spies. “Compared to 2016, considerably higher absolute increases in issuance volumes are not expected for any covered bond segment.

“That said, higher issuance activity is pencilled in for new markets and several smaller segments, such as Poland, Singapore, Austria and Portugal.”

Photo: Assorted right wing EU politicians, including Marine Le Pen and Geert Wilders; Copyright: EU/European Parliament