Uncertainty surrounding ECB tapering and post-summer issuance should provide “ample opportunities” for the buyside in the covered bond market, according to two major investors, who say value can be found in corners of the asset class even at current historically tight spreads.

Moritz Rieper, portfolio manager at Deutsche Asset Management (pictured), said that although covered bonds still trade at historically suppressed levels, yields have recovered from their lows in line with an upward shift in the yield environment. Around one-third of bonds in the iBoxx Euro Covered Index are trading at negative yields, down from around 86% last September, when the average yield of bonds in the index hit record lows.

“We welcome this development as, in addition to the fund’s return and volatility, the absolute portfolio yield is an important factor for our customers,” he told The Covered Bond Report.

Rieper added that even in today’s environment, the covered bond market offers plenty of opportunities, especially for investors able to diversify across different fixed income asset classes.

“For example, Pfandbriefe, despite the recent rally, still offer a decent pick-up over German government bonds and senior financials seem increasingly expensive versus covered bonds of various legislations, especially volatility-adjusted,” he said.

Jozef Prokes, fixed income portfolio manager at BlackRock, said current outright spreads and yields mask “relatively large volatility” between different sectors in the covered bond market, which investors can benefit from if their mandate is sufficiently flexible.

“This year, relative value strategies have delivered surprisingly good returns in both the covered bond and SSA markets and likewise worked in the corporate senior space,” he said. “Even today we still see a number of opportunities in these markets, like French covered bonds or long dated supranationals, to name a few.”

The attractiveness of German Pfandbriefe versus Bunds has been slightly diminished by a recent rise in Bund yields, but, Prokes said, the tightening of Bunds to swaps is not yet substantial enough to prompt investors to switch from covered bonds into govvies.

“A large part of the moves in spreads is attributable to swap spread moves, but naturally at some point this will start to exert pressure on covered bond and agency spreads versus swap rates,” said Prokes. “These moves indeed can lead to switching activity in some core jurisdictions, but we are not there yet in my opinion.”

Covered bond spreads have remained stable or ground marginally tighter in recent weeks, on the back of no issuance and scant turnover, but this is widely expected to change in the coming months.

The market’s consensus is that on 7 September the ECB will announce a tapering of its QE purchases, including those under the covered bond purchase programme (CBPP3), commencing in January 2018. The covered bond market as a whole is expected to widen on the back of any such announcement, and although forecasts for the exact impact vary, most analysts expect spreads to develop along similar lines. Covered bonds that have benefitted the most from CBPP3’s spread compression, such as those from peripheral markets, where ECB buying has been relatively heavy and issuance relatively light, are expected to widen the most. Any widening could, however, be tempered by relatively low supply, with analysts forecasting around Eu35bn of euro benchmark issuance in the second half of the year.

“For dedicated covered bond benchmark investors, the remainder of the second half of 2017 should provide ample opportunities for active positioning, looking, for example, at the uncertainties related to the ECB’s tapering expectations and the upcoming primary market activity in September,” said Rieper. “We expect the overall European yield environment to slowly continue its current path of normalisation towards higher levels, driven mainly by a shift in the ECB’s monetary policy and expectations thereof.

“This, together with the expected supply at the beginning of Q4 and illiquidity at year-end, could well lead to moderately higher spreads and more differentiation within the covered bond universe. However, this view is market consensus and we need to acknowledge the ongoing support by the ECB, be it reinvestments, or tapered but still meaningful monthly CBPP3 amounts.”

Rieper said Deutsche AM’s general investment process will not change as a result of the ECB tapering.

Prokes said that moves in the covered bond market will need to be put into perspective versus the reaction in other markets.

“I think covered bonds have already underperformed super-senior bonds, for example, which will keep a lid on the overall spread moves,” he said. “Even if you believe in a September announcement and negative market reaction to QE tapering, covered bonds might not be the best market to express this view in.

“Even for jurisdictions trading at large premiums to respective government bonds, the reaction might be still larger in the more liquid assets, as free-float will continue to play an important role.”

As the ECB’s share of the outstanding covered bond market has grown, some market participants have complained of real money investors being crowded out.

Rieper believes the health of the market will improve when the ECB begins winding down CBPP3, but said this process will be slowed by factors such as the reinvestment of maturing bonds.

“This is likely to be a slow recovery due to the significant percentage of the eligible covered bond market the ECB is already holding, the tapered but continued purchases, as well as the reinvestments it undertakes going forward,” he said.

The investors meanwhile said they would welcome progress in developing covered bond jurisdictions in the second half of the year.

“Being from central Europe, I am very keenly watching the CEE market, where we are looking for legislative upgrades in both Slovakia and Czech Republic,” said Prokes. “Provided these upgrades are sufficiently robust, both jurisdictions are of interest to me.”