Polish Soldiers

29 May 2014 | Richard Kemmish


Churchill was once asked what he thought of the Polish soldiers fighting in the British army during the second world war? He replied that there is only one thing wrong with Polish soldiers <pause for dramatic effect> there aren’t enough of them. 

Much the same could be said of covered bonds. The size of the Pfandbrief market has been falling precipitously since Anstaltslast and Gewahrtragerhaftung for German state banks were abolished by the EU in in 2005 (presumably because they couldn’t pronounce them) but last year it looks like the entire market will have shrunk slightly. More worrying for traders, bankers and investors, it’s the jumbo market that seems to be bearing the brunt of the decline. With over-subscriptions at the levels that they frequently are, large investors are increasingly resorting to reverse enquiry.
 
On the other hand, demand for covered bonds is healthier than ever. Yes the growing appetite for yield / tolerance for risk is pushing some investors from covered to unsecured bonds, but that same trend is pushing other investors away from govvies and agencies and into covered bonds. To the extent that covered bonds are a point on a risk/return continuum what is really important to overall demand is structural change and changes to the risk/return trade-off.

The structural growth in demand for covered bonds is a consequence of regulatory changes, in particular the demand for bank liquidity assets and collateral (for ECB repo operations, central clearing, derivatives collateral support agreements, etc).

The change to the risk/return trade off is a result mainly of the Bank Resolution Directive, the implications of which are clearly not priced in to the relative value of senior and covered bonds yet (unusually it looks like the rating agencies will be ahead of the market on that one). 

Should we worry? The immediate and obvious answer is yes if you are an investor, no if you are an issuer. Economics 101: spreads will narrow. 

But in the longer term, we should all worry. Unlike spreads, liquidity is not a zero-sum game between issuers and investors. And in the medium term changes to the supply/demand equilibrium will cause a change to the level of resources that players allocate to the market (Economics 102). More simply covered bonds run the risk of becoming irrelevant. The fixed costs for an investor of being active in any asset class are high and growing. Not enough supply and they won’t even bother trying to understand the difference between cedulas and obligations foncier. 

The implications? In brief (I try to keep these posts under 500 words), industry needs to reduce the fixed costs of investing (the covered bond label being a good example), to use techniques developed in the covered bond market to create other points on the risk/return continuum (for example, Obbligazioni Bancarie Collateralizzate) and to increase the supply of covered bonds from new countries with currently undersized covered bond markets.

Poland to the rescue again?


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