Heightened interest in covered bonds and more attractive yields bode well for an anticipated increase in supply next year, but the evolving rate environment could mean investors are more defensive with respect to duration and jurisdiction, according to buyside surveys from ABN Amro and Natixis.

ABN Amro’s fixed income group surveyed 179 investors, including asset managers, central banks/SSAs, insurers and bank treasuries, of whom around 85 answered questions specific to covered bonds within a broader questionnaire on the bond markets. Natixis’s covered bond-focused survey took in 31 investors representing a cross-section of countries and investor types.

Looking back briefly over 2021, ABN Amro found that almost two-thirds of investors surveyed reduced their covered bond portfolios this year, while only 7% of investors increased their holdings. Around two-thirds of those who reduced their holdings (43% of the total surveyed) cited the low yield environment as the key reason for this, including 60% of both bank treasuries and insurers/pension funds who responded.

“This likely reflects that the latter mostly need a positive yield,” said ABN Amro analysts, “while most bank treasuries need a return above the deposit rate.”

Only 4% of respondents to ABN Amro’s survey decreased their covered bond holdings due to low supply, and, looking into 2022, Natixis expects that an anticipated increase in new issuance would be met with eager demand, with their survey finding investor appetite to be at its highest in three years – 89% said they plan to maintain or increase their covered bond investments, a jump from last year’s 75%.

“It is worth mentioning that the rise of yields is also a driver for higher investments,” said Jennifer Levy, senior analyst at Natixis. “Indeed, when asking how the recent hike in yields impacted their covered bond investment strategy, 35% of respondents answered that they would increase their holdings.”

She said this could be explained by some investors’ minimum yield targets (33% of the investors surveyed), which generally exceed 0%.

Developments in rates are likely the reason why more investors plan to shorten duration in the coming year than was the case a year ago, according to ABN Amro analysts. They noted that while only 7% of respondents planned to shorten duration in their survey last year, a quarter of investors (mainly asset managers and bank treasuries) now anticipate shortening duration, mostly by one or two years.

“The turn in sentiment likely reflects the recent rise in base rates,” said the analysts, “as well as anticipation of steeper curves in 2022.”

In anticipation of a rise in rates, a majority of respondents have shifted their focus to the belly of the curve, with 34% of investors saying they will focus on four to seven year maturities and 20% indicating that their sweet spot has changed from 10 years or more to seven to 10 years.

Natixis’s similarly found that 35% of investors prefer to focus on the belly of the curve (six to seven years) and 29% saying they prefer the longer part of the curve up to 10 years.

“Given inflation fears, investors are not keen to add duration in the current environment,” said Levy.

Most investors surveyed by ABN Amro expect covered bond spreads to widen, with 53% anticipating a modest move of up to 3bp, and 13% a widening of more than 3bp.

ABN Amro: Where are covered bond spreads at end-2022?

Source: ABN Amro

Investors surveyed by Natixis expressed similar views, with 59% expecting spreads to widen between 2bp and 10bp, although Levy noted that a relatively large share (37%) of investors see spreads stabilising at their current level.

Over 80% of Natixis respondents consider covered bonds attractive versus SSAs and their respective government bonds, particularly in the short to medium part of the curve. However, ABN Amro respondents were more evenly split, with just over half finding covered bonds still attractive relative to SSAs, but a large minority to rebalance their portfolios in favour of SSAs as an attractive triple-A alternative. ABN Amro analysts nevertheless noted that the share deeming covered bonds attractive in this respect was higher than last year.

The uncertain rate environment may also have affected investor preferences with respect to jurisdiction, according to ABN Amro’s findings.

Investors surveyed increasingly see value in core covered bonds, with these ranking first in where investors said they see higher relative value, followed by semi-core (which ranked first last year) and the Nordics. Canada dropped from second to sixth place, while peripheral covered bonds fell from third to fifth.

“I found it interesting that most investors seem to have become a bit more cautious moving into the next year,” said Joost Beaumont, senior fixed income strategist at ABN Amro, told The CBR. “It shows that the search for yield has lessened a bit.

“It can also reflect that Canada and the periphery are trading at relatively tight levels, so if you expect a bit of market volatility, then it is better to be positioned in core or semi-core countries.”

Natixis’s survey, however, found 59% of respondents deeming non-Eurozone covered bonds to be best from a risk/reward perspective, with 23% choosing core/semi-core and 18% peripheral covered bonds.

It also suggested that nascent covered bond jurisdictions could develop further, especially Eastern European countries, with the possible introduction of a pan-Baltic framework.

“Thanks to their eligibility to the LCR, ECB repo, and pick-up versus core Eurozone countries, 64% of investors surveyed can invest in this region, up from 41% last year,” said Levy.

Asian covered bonds ranked seventh in ABN Amro’s survey, but the share of investors seeing value in the region roughly doubled, and 36% of investors surveyed by Natixis are able to invest in Japanese and South Korean covered bonds.