Euro covered bond supply in 2018 is expected by most analysts to fall short of 2017’s. However, uncertainty pervades on factors from unusually low redemptions and rising TLAC/MREL needs to new and returning issuers, with CBPP3 a rare constant even as QE nears its end.

Estimates from 13 analysts for next year’s euro issuance range between Eu97.5bn and Eu122bn, averaging Eu107bn. Most forecast that supply will be roughly in line with or slightly below 2017’s, in the region of Eu100bn-Eu110bn.

Year-to-date euro benchmark issuance stands at Eu111.5bn, including taps, and with the seasonal break approaching the market is now widely thought to be closed for the year. This is well below the Eu120bn-Eu125bn forecast by most analysts at the end of last year, but roughly in line with revised forecasts issued by some towards the end of the first quarter of 2017.

Analysts’ figures for euro benchmark redemptions in 2018 vary slightly, from Eu87bn-Eu90bn, but all expect net supply to be positive for the first time in three years.

France and Germany are once again expected to be the most active jurisdictions in terms of euro benchmark issuance, with the Netherlands, Canada and Norway completing most analysts’ top five.

A key theme in 2018 will be the eventual unwinding of the ECB’s asset purchase programme (APP). As of 1 January, the Eurosystem’s monthly QE target will be lowered from Eu60bn to Eu30bn, with purchases to continue until at least the end of September.

“When we think of 2018, the 1980s movie Back to the Future springs to mind,” says Frank Will, head of covered bond research at HSBC. “In it, protagonist Marty McFly – with the help of the eccentric scientist Doc Brown – strives to go back to where he belongs after causing havoc.

“Like McFly, the covered bond market is also in the process of slowly returning to its natural, undistorted state after many years of heavy central bank interference.”

However, Will notes the QE tapering process will be a long and winding road.

Net CBPP3 purchases are widely expected to remain stable at around the current pace, of Eu3bn-Eu4bn per month, and with some Eu17bn of maturing CBPP3 holdings set to be reinvested over the next 12 months, analysts are unanimous that Eurosystem purchases will continue be supportive for euro covered bond issuance next year.

The prospect of the end of the CBPP3 is seen as having the potential to spur issuers to make the most of the ECB’s full presence in the market in the first three quarters of the year.

“The closer we get to September, issuers will in our view consider pre-funding 2019 covered bond needs in 2018 to benefit from a full-speed CBPP3 rather than just relying on redemption reinvestments,” says Florian Eichert, head of covered bond and SSA research at Crédit Agricole. “It only takes a few basis points of expected widening in most cases to make pre-funding and warehousing liquidity the superior option.”

Reasons to be negative

As demonstrated by the variance in supply forecasts, however, other factors bring substantial uncertainty.

Analysts cite the relatively low level of benchmark redemptions – the lowest since 2008 – as being a main driver of a potential fall in supply.

“Moreover, annual coupon payments from outstanding euro benchmarks should also shrink from around Eu20bn to Eu16bn,” says Ted Packmohr, head of financials and covered bond research at Commerzbank – who forecasts around Eu100bn of supply.

“Overall, payments to investors in 2018 should thus be a whopping Eu37bn lower than this year and almost Eu70bn lower than in 2016.”

However, one analyst, whose forecast is at the higher end of the range, disputes the usefulness of redemptions as an indicator of issuance activity.

“I don’t really buy into the argument that due to the lower redemptions we’re going to see lower supply,” he says. “What we’ve seen in recent years is that redemption figures are not a good guide for covered bond supply – otherwise the covered bond market would not have shrunk the way it has.”

Issuers’ funding needs are also deemed to be limited because of an inflow of deposits in many countries and, within the Eurozone, by the take up of the ECB’s TLTROs earlier this year, which is seen as one of the main factors responsible for 2017 issuance falling below initial estimates.

“We understand that most TLTRO I drawings were rolled into TLTRO II transactions,” says Packmohr. “The final maturity of the first series in September 2018 should thus only be of minor importance.

“The TLTRO II tranches, on the other hand, are not maturing before 2020-2021, and they are not required to be repaid early even if the lending targets are undershot.”

However, some analysts say that banks no longer having access to short-dated funding via new TLTROs could increase issuance of short dated covered bonds, in particular in the periphery.

And Crédit Agricole’s Eichert – who expects Eu120bn of issuance – plays down the negative impact of the TLTROs, noting that some banks drew down substantial volumes and could begin repaying the ECB money early, with Crédit Agricole ECB strategists expecting an early repayment pace of Eu45bn per quarter.

“This might be a bit high but will still contribute positively to covered bond issuance next year,” he says.

The needs of some banks to issue TLAC/MREL-eligible senior debt is also expected by many analysts to be a drag on covered bond issuance from certain jurisdictions, with issuers potentially focussing on the former at the expense of the latter. This has been a perennial factor in outlooks of recent years, but deadlines are nearing.

“The TLAC guidelines in particular are likely to tie up capacity at the institutions affected (G-SIBS) which will have to meet the criteria by the beginning of 2019,” says Alfred Anner, senior covered bond analyst at BayernLB. “The timescale is not quite so strict for MREL, and in most cases transitional rules will apply until 2022.

“However, many institutions will already want to comply with the final regulations in advance, and the focus will therefore shift earlier to MREL funding. Issuers will probably therefore adjust their funding mix and replace some of the covered bond funding with senior funding non-preferred.”

2017 saw many banks issue inaugural senior non-preferred bonds after the markets opening last December. HSBC’s Will notes that several Spanish banks have stated plans to issue senior non-preferred debt at the expense of covered bonds next year, with BBVA to issue Eu4.5bn of senior non-preferred in 2018, replacing upcoming covered bond redemptions, and Santander stating that it is likely to refrain from covered bond issuance in 2018.

However, some analysts suggest that senior non-preferred issuance does not necessarily cannibalise covered bond issuance, and note that some countries will not have legal frameworks for SNP issuance in place until later in the year, arguing that many banks will choose to wait for such legislation.

Reasons to be positive

Those that forecast an increase in year-on-year issuance point to the potential for jurisdictions that have been relatively dormant in 2017 to increase their contribution. In particular, they cite expected higher supply from the UK, which provided Eu4.75bn of euro benchmark supply this year, and Spain, which provided Eu2.5bn.

Cristina Costa, senior covered bond analyst at SG, expects 2018 supply to be “flattish” to this year’s, at around Eu116bn. She predicts that Spanish issuance will increase to Eu6bn, even accounting for the mitigating effects of TLAC/MREL needs and low maturities.

“There are increasingly positive signals coming from the economy: NPLs are decreasing; unemployment is inching down, albeit from high levels; and property prices are still recovering,” she says. “Spanish banks’ main challenge will be their low profitability in the context of low interest rates.

“Wide senior unsecured spreads and potential prefunding ahead of the ECB QE exit, combined with continued CBPP3 support, should favour issuance, particularly at the longer end of the curve.”

Some analysts foresee as much as Eu7bn euro benchmark issuance from the UK, citing issuers’ increased funding needs after the conclusion of the Bank of England’s Term Funding Scheme.

The emergence of new covered bond issuers, some of which debuted in 2017 and some of which are expected to do so in 2018, is also expected to add upward pressure on issuance.

2017 saw the entrance to the euro market of new and returning names across the world, from Rabobank to National Bank of Greece, and analysts say that the addition of more debutants – and potentially new jurisdictions – could have a positive, albeit limited, impact on supply.

“In addition to the well-known candidates from core countries such as TSB or Virgin Money, we are also optimistic for further names from lower-rated countries to enter the market since the way has been paved by the successful entrance and return of Portuguese and Greek banks,” says Commerzbank’s Packmohr. “Their issuance projects have clearly demonstrated that there now exists a wide investor basis for benchmark covered bonds of lower credit quality.

“This should also benefit other names and countries.”

Furthermore, market access is expected to be consistent. Anticipated political risks featured highly in many analysts’ forecasts for 2017, when Brexit negotiations, troubles in Italy and the rise of populism across Europe were seen as having the potential to disrupt issuance, but in 2018 such concerns are less prominent after last year’s fears proved unfounded.

Risks including but not limited to political uncertainty in Italy and Spain – specifically Catalonia, tensions on the Korean peninsula and, once again, Brexit – are on analysts’ radars, but covered bond markets are expected to remain resilient.

Reasons to be uncertain

Analysts on both sides of the forecast divide agree that an important theme will be the relationship between covered bond and senior spreads, which could make covered bond less attractive for issuers.

“Senior-covered bond spreads have become so tight that in some cases senior preferred debt has become the cheapest funding instrument for issuers, especially in non-Eurozone countries,” says Eichert. “Depending on the hedging approach, anything inside 20bp can mean covered bonds are too expensive.

“We could therefore imagine that some banks use short-dated senior preferred debt issuance to wait for their SNP products to be in place.”

Similarly, issuers will have their eye on cross-currency bases, after many successfully tapped the US dollars and sterling covered bond markets this year at more favourable funding levels than were on offer in euros.

“This year we have witnessed substantial issuance interest from non-Eurozone banks move towards other currencies,” says Commerzbank’s Packmohr. “If this trend were to reverse again, it could thus markedly benefit activity on the euro benchmark primary market.

“For the time being, however, we do not expect any significant change in the general conditions here.”

Recent regulatory announcements have also muddied the waters.

SG’s Cristina Costa says, for example, that the ECB’s recent decision to make the conditional pass-through (CPT) covered bonds of sub-investment grade issuers ineligible for CBPP3 as of 1 February could result in lower issuance, suggesting that supply could be closer to Eu100bn-Eu110bn than her forecast of Eu116bn.

However, another analyst notes that the market is awaiting clarification from the ECB on adjustments to the haircuts it applies to retained soft bullet and CPT covered bonds, which are due to be announced by year-end.

“I think the changes to CBPP3 eligibility for CPT covered bonds point to the direction the ECB may want to go in terms of repo treatment,” he says. “If you consider the impact of a potential mark-up for soft bullet covered bonds under the ECB repo regime, then I think those banks which use this option extensively may want to switch to public covered bond funding.”

The analyst notes that over the last few days, French, Portuguese and Greek banks have made heavy use of retained funding.

“That could add upward pressure to funding figures,” he said.