Any post-summer widening of euro covered bond spreads on tapering news is likely to be moderated by low supply and ECB firepower, according to bankers. A rise in yields amid shakier conditions could increase demand at the long end, but spreads there are deemed more vulnerable.

After a slight widening that brought the market away from historic tights, euro covered bond spreads have remained stable in recent weeks, in which there has been no benchmark issuance and limited turnover. Issuance is not expected to resume until the end of August, with the market feeling the effects of the traditional summer slowdown.

Market participants mostly agree that the major driver of spread developments for the rest of the year will be the ECB. If, as is widely expected, the ECB announces after its next governing council meeting on 7 September that it will begin tapering its asset purchase programme (APP), spreads are expected to widen across all jurisdictions.

“With issuers facing uncertainties regarding the future development of spreads, they will be willing, or forced by investors, to pay higher new issuance premia,” adds Franz Rudolf, head of financials credit research at UniCredit. “This will lift covered bond curves wider, which in turn may increase the pressure on issuers to do some prefunding of their 2018 funding needs in order to avoid even higher spread levels.

“With increased supply, NIPs will grow even further.”

Some have forecast that when the programme is wound down spreads could in the long term return to near pre-CBPP3 levels, and spreads of covered bonds that have benefitted the most from CBPP3-induced tightening – such as peripherals and longer-dated bonds – are expected to move most markedly, with differentials between jurisdictions increasing.

However, euro covered bond supply is forecast to be relatively modest in the rest of the year – with many analysts penning in around Eu35bn for H2, implying that net 2017 supply will be negative – and market participants say that this, combined with sustained high demand, will temper spread widening in the nearer term.

“As things stand, supply will remain relatively moderate for the rest of year,” says Ralf Grossmann, head of covered bond origination at Société Générale. “That is key, because the ECB firepower is still big enough to help primary market deals and support spreads through the primary market.”

“I am in the camp of saying that any spread widening will be moderate. Yes, we will trade away from the lows, but it will not be a dramatic move.”

A syndicate banker agreed.

“The only thing that would cause a big change in the spread picture is a fundamental change of fundamentals, but I don’t see this coming,” said a syndicate banker. “Europe is doing as normally, either growing slightly or receding slightly, and I don’t see this changing to a big extent.

“I would not take it for granted that 10 year French covered bonds will always price at 2bp, for example, but I don’t think that in the foreseeable future they will be pricing at 20bp either. I have no idea where this kind of move should come from.”

Market participant note that other factors arising outside the Eurozone could have an effect on the wider market this year, citing tensions between the US and North Korea.

“These geopolitical tensions are of course concerning, but they are not negative for high quality assets like covered bonds,” said SG’s Grossmann. “Core government bonds and high quality covered bonds are a defensive investment, so these developments play in their favour.

“But I am not expecting it to be a major driver after the summer.”

Syndicate bankers said that in terms of executing deals on the primary market, the confirmation of any tapering and its effect on spreads should not prevent any issuers from coming to the market.

“Peripherals are probably more dependent than others on the implicit guarantee from the ECB that they will buy a big part of their deal, which some non-political investors might not want to absorb,” says one. “But most recent transactions from southern Europe were solidly oversubscribed.

“The backlash potential is far more pronounced in, say, a Portuguese covered bond than HSH Nordbank, and spreads will have to go up to an extent, but I don’t think it will make deals that much harder.”

Forecast positive for yield hunters

While spreads have remained compressed, covered bond yields have offered investors more encouragement this year.

Around one-third of bonds in the iBoxx Euro Covered Index are trading at negative yields and Günther Scheppler, senior covered bond strategist at DZ Bank, notes that this is down from some 86% last September, when the average yield of bonds in the index hit record lows.

The rise in yields since has been focussed most of all on bonds at the long end, resulting in a steepening of the yield curve. The average yield differential between two year and 10 year covered bonds reached a record low of 35bp last August, but has increased to stand at around 125bp.

This steepening will continue in the second half of the year, according to Scheppler, who expects yields at the short end – which typically react to changes in the key interest rate – to remain unchanged.

“From our perspective, increased inflation expectations are primarily responsible for the general yield increases seen at the long end of the maturity curve over the past few months,” he says. “Between H2 2016 and the end of January 2017, inflation expectations rose considerably, before dropping off again somewhat.

“Should our prediction of an unchanged key rate in the Eurozone for the coming quarters with simultaneous increases in the rate of inflation come to fruition, it can be assumed that the yield differential between two year and 10 year covered bonds will increase somewhat further.”

If the ECB announces QE tapering this autumn, the yield differential could grow even more substantially, with swap spreads at the long end set to widen more markedly than the short end. Such a move could increase the attractiveness of long-dated covered bond for some investors, but Scheppler warns that the spreads of such bonds could widen disproportionately, as they have benefitted more from the ECB’s compressing effect.

“Investors who want to minimise the negative consequences of a relative underperformance of longer-dated covered bonds would be well advised to promptly shorten the duration of their covered bond portfolio.”

Grossmann agrees that a steepening of the yield curve would be a normal market reaction to the unwinding of ECB QE and normalisation of monetary policy.

“This is not specific to covered bonds but covered bonds will benefit from that,” he says. “If yields increase, in particular at the long end, that will of course help the real money investors that are hunting for yield and have moved out into longer tenors and more risky assets. Given how things are expected to develop and if geopolitical tensions remain, maybe investors will move back into safer assets like covered bonds. We have seen investors buying long positions in June and July, but current covered bonds yields are still some way away from their targets.

“For the performance of this year, I think there is even a risk for portfolio managers if they shorten the duration of the portfolio too much,” he added, “because then you can miss moves like the one at the beginning of July, when yields started to decrease again. If you miss that trade, that will have an impact on the performance of your portfolio.”

Even with potential moves in yields, bankers say the seven year maturity is likely to remain the sweet spot in the covered bond market this year, with longer-dated trades also working well.

Another syndicate banker suggests a sustained rise in euro spreads and yields could encourage issuers to take advantage of competitive funding levels on offer in the US dollar and sterling markets.

“The primary thing I would take from these moves is that the covered bond landscape globally looks more opportune than perhaps it was,” he says. “I think that in the end of Q3 and Q4 we will still have supply, but euros will be a smaller part of that proportionally versus other currencies.”