Covered bonds are widely expected to widen further in the first several months of the year before recovering in the second half, with anticipated rate cuts key to this scenario, while analysts cite commercial real estate headline risk and supply factors as determining potential winners and losers.

After widening of some 14bp in the iBoxx Covered Bond Index this year, of which around 9bp occurred since September, Jennifer Levy at Natixis foresees spreads widening up to 5bp in the first months of 2024, given an expected high level of supply in the first quarter, likely Bund swap spread tightening, the absence of ECB support, and the potential reopening of the long part of the curve.

However, Levy notes that the tone could then improve, in the second half or even sooner, in anticipation of an interest rate cut.

This pattern of widening to a peak sometime in the second quarter is widely anticipated by analysts – DZ Bank’s Verena Kaiser, for example, expects the iBoxx Covered Index to be widen 10bp to a peak of around 40bp midway through the second quarter, before recovering to around 30bp before year-end.

LBBW’s Karsten Ruehlmann anticipates a potentially more significant widening in spreads of from 10bp to as much as 15bp at the peak. He highlights several factors contributing to spread pressure in 2024: high supply needing to be absorbed by real money investors; the interest rate outlook, with rates not being cut until autumn 2024 at the earliest; real estate markets’ continued search for a “new normal”, particularly for commercial real estate; and persistent geopolitical risks potentially impacting primary market opportunities.

Balanced against these, Ruehlmann cites: a high degree of rating stability; persistently high yields; the repricing that has already occurred across most jurisdictions; and relative value versus similarly safe asset classes.

ING’s Maureen Schuller, meanwhile, sees few likely negatives for covered bond spreads after their widening this year and last, even if there could be some performance softness at the start of the 2024, with new issue premiums likely to stay elevated against the supply backdrop.

“We do not believe that covered bonds will widen much further,” she says, expecting the index to stay close to the 30bp level during the coming 12 months.

Schuller notes that spreads are around 4bp from highs reached in 2020 on the back of the Covid-19 pandemic, and already wider than those peaks in various countries.

“Spreads could come under more widening pressure, though, if returning inflationary concerns were to lead to further unexpected central bank interest rate hikes,” she says. “More aggressive quantitative tightening is another factor that would weigh on performance, for instance if the ECB were to start selling bonds held under its APP or PEPP programme.

“Considering the impact thereof on sovereign spreads we do not consider such a step as likely.”

While macro factors may be set to drive the overall direction of spreads in 2024, analysts expect increasing differentiation among covered bond issuers, jurisdictions and collateral.

“With the complete cessation of ECB purchases under CBPP3, credit issues have already moved back into the focus of market participants,” said DZ’s Kaiser, “which is likely to continue in the coming months.”

Real estate, notably commercial real estate, is never far from the headlines these days and is an area where analysts adopt a degree of caution.

According to SG analysts, the health of the real estate sector is not worrying enough to significantly impact covered bond spreads, which should remain resilient to anything barring a major crisis. They highlight analyses they conducted on France, Germany and Sweden, with only the latter showing much evidence of real estate being a driver for spreads, with post-GFC banking regulation potentially having helped.

“Nonetheless, to avoid any bad surprises, we would likely avoid CRE-backed covered bonds,” add SG’s analysts, “or at least favour covered bonds backed by residential mortgage cover pools.”

Indeed, DZ’s Kaiser notes that the greater risk for mortgage covered bonds is not in the credit quality of cover assets, but rather in a crisis of confidence, which could impair the sustainable refinancing of mortgage financiers via the capital market. Germany and some Nordic issuers are identified by analysts as potentially susceptible to negative sentiment towards such assets.

Canada is highlighted by some analysts as a good bet in 2024, partly thanks to credit quality, and partly due to favourable issuance dynamics.

“Canada stands out as a prime jurisdiction for ‘reduced supply’ induced spread outperformance in FY24,” say JP Morgan analysts.

Following benchmark supply across all currencies of around €60bn-equivalent in 2022 and around €38bn this year, they expect €30bn in 2024, noting that if around half of this is in euros – as has been the case in the past two years – it would imply barely any net Canadian euro benchmark issuance in the coming year, given €14bn of such redemptions.

“In fact, we are forecasting no net supply of euro benchmark prints from outside the Eurozone in FY24,” add the JP Morgan analysts, “which should also lend support to euro covereds from other Anglo-Saxons such as Australia and the UK (which typically diversify into non-euro funding as well) even though we expect aggregate issuance volumes from those countries to remain elevated.

“Overall, we see room for outperformance of Canadian covereds versus Australian and UK risks.”