Forecasts for 2018 euro covered bond supply have been raised after the first half exceeded all expectations, with some analysts expecting EUR35bn-EUR40bn of issuance in the second half. The impact of latecomers and TLTROs is uncertain, while restrained widening is foreseen.

In the first half of 2018 euro benchmark covered bond issuance totalled EUR87.15bn, including taps, some EUR10bn more than was issued in the first half of 2017, making it the fourth strongest half-year in the last 10 years.

Euro benchmark issuance this month has already hit EUR7.25bn after just one week, more than has been issued in the whole of July in most recent years (see separate article), bringing year-to-date supply to EUR94.15bn.

Issuance is therefore well on track to surpass forecasts, with most analysts at the end of last year predicting that 2018 supply would amount to EUR100bn-EUR110bn.

“Supply in the first half has been stronger than we anticipated,” said Frank Will, head of covered bond research at HSBC. “We expected a big chunk of our full year forecast of up to EUR110bn to be issued in the first half of the year as many issuers expected rising yields as a result of the potential end of ECB net purchases. Moreover, Eurozone issuers probably wanted to ensure a high ECB share in their order books, giving an incentive to frontload their funding in 2018.

“The actual primary market activity, however, even exceeded our expectation and net supply temporarily reached a record high of EUR35bn.”

Analysts at NordLB said that in addition to “anticipatory effects” – as issuers attempted to get deals done before the end of CBPP3 was announced – the higher than expected euro issuance was driven by movements in basis swaps that made euro-denominated trades more attractive than US dollar-denominated trades for issuers outside the Eurozone.

Based on the volume of year-to-date supply, the NordLB analysts have raised their 2018 issuance forecast to EUR124.8bn, expecting EUR39bn of issuance in the second half of the year. However, they said pre-funding exercises – i.e. issuers bringing forward deals for 2019 into 2018 – could drive 2018 issuance even higher than their revised forecast.

“For example, covered bonds amounting to EUR32.3bn will mature in the first three months of 2019, with EUR12.95bn of this maturing in January 2019 alone,” they said. “Since the current market environment is dominated by uncertainty regarding the end of net purchasing by the European Central Bank, the extent to which pre-funding is actually taking place is unclear at the moment.

“We presently suspect that in an environment which will be characterised by a further rise in spreads in the second half of 2018, issuers will tend to hold back.”

Karsten Rühlmann, senior investment analyst at LBBW, has also revised his 2018 supply forecast, raising it from EUR97.5bn to EUR120bn, implying some EUR35bn of supply in the second half of the year. He expects more supply from France, Germany, Canada, the Netherlands and Austria, in particular.

“Against the backdrop of a further scaling back of the ECB’s purchase activities, issuance activity is expected to remain buoyant in the second half of the year,” he said. “However, it should remain well below that of H1.”

Covered bond benchmark issues year-on-year comparison

Source: LBBW research, Bloomberg

Latecomers and TLTROs raise uncertainty

Ted Packmohr, head of financials and covered bond research at Commerzbank, said the greatest potential source of sustained brisk covered bond issuance in the second half of the year could be the substantial pool of issuers who have not yet been active this year. This trend made its mark on the primary market last week, he said.

“Of the nine banks that have placed new euro benchmarks over the recent days, six were active in this market segment for the first time this year – MünchenerHyp, Stadshypotek, Intesa, RLB Oberösterreich, HSH Nordbank and Mediobanca,” he said. “This is an unusually high number for this time of year.”

Packmohr said there are still 49 benchmark issuers that were active in at least one of the two previous years that have not yet made an appearance this year.

“We would be surprised if we did not see some of these names in H2,” he said.

He suggested that if 10-15 of these issuers return the market in the second half of the year, this could result in up to EUR15bn of supply from this channel alone – noting that the average size of euro benchmarks this year is around EUR800m and that the issuers in question could make multiple appearances.

“Add to this the issuers who were already active, even in the case where only one-third of these placed one additional new euro benchmark each – another EUR20bn plus – this would already mean that a remarkable primary market result of some EUR130bn would be within reach for the year as a whole,” he said.

Analysts also said the potential for large TLTRO II repayments in September and December injects some uncertainty into supply forecasts for the rest of the year.

“Depending on their deposit rate hike expectations (which seems unlikely before autumn 2019 according to the ECB), banks may issue (longer-dated) covered bonds to repay parts of the huge TLTRO-II amounts ahead of their scheduled maturity, locking in the low interest rate environment,” said HSBC’s Will.

NordLB analysts said, however, that based on conversations with issuers they consider early repayment and an associated increase in covered bond funding unlikely in 2018.

Spread widening foreseen

Analysts noted that, in contrast to previous years, the covered bond market was in the first half of 2018 characterised by widening spreads. They largely attributed this trend to the strong issuance activity driven by issuers anticipating the end of CBPP3 and to the ECB twice reducing the typical size of its orders for Eurozone covered bonds under CBPP3, first from 50% to 40% in March and then from 40% to 30% in April. Issuers were forced to pay larger new issue premiums – at times as high as 10bp – as investors’ power increased.

Among core jurisdictions, French covered bond spreads underperformed, analysts highlighted, widening by around 10bp. The most significant widening was seen in the Italian market, where spreads rose 30bp-50bp on the back of political risks.

“Driven by the rollercoaster ride of BTP yields, Italian covered bonds were not able to decouple from the underlying sovereign trend and OBG spreads widened severely across the curve and have not yet recovered,” said Will.

The NordLB analysts forecast that by the end of this year spreads in the primary market will widen by a further 10bp-15bp for core Eurozone issuers and by 20bp for non-core issuers, on the back of the ECB reducing its presence in the market.

“Movement in the secondary market is expected to be even more pronounced, but we would put this down primarily to a high degree of illiquidity,” they added. “Regardless of the segment in which the Eurosystem is conducting its purchasing, we also expect spreads for non-Eurozone issuers to widen as a result of spill-over effects.”

However, analysts stressed that any spread widening in the second half will be moderated by the ECB’s ongoing presence in the market, with the Eurosystem expected to maintain its covered bond purchases as part of its QE programme through to the end of the year.