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"So which covered bonds should I buy then?"

29 August 2014
Richard Kemmish


The question wasn’t any less interesting because it came from a friend of mine, over a beer and that the friend in question works in advertising and therefore doesn’t have, a) a clue about what a covered bond actually is or b) any money to invest.

The stock answer is that if you think spreads generically are going tighter you should buy the cheapest ones, if you think they are going wider, the most expensive ones. That is, go with the beta. And if you are confident of your view put more duration in your portfolio, if not go short.

Which broadly translates to buy that 10 year cedulas. The combination of T-LTRO (don’t you just love that ‘T’? implies that the first two LTROs were just scatter guns firing liquidity at anything that moves) and the growing inevitability of QE as eurozone inflation heads lower means that technicals can only be supportive.

Of course there are risks, geo-political, CoCo panic, or unknown unknowns. But they would have to be very significant to overcome that technical support, as the markets has demonstrated by blithely ignoring every piece of bad news recently. The Draghi factor is also significant – bad news is good as it makes QE that little bit closer. As Lenin said: ‘worse is better’.
 
So far, so obvious.

Could the final definition of LCR confuse this picture? To the extent that the eligibility criteria are not revealed until the end of September, possibly. There is always the potential for a bond that we thought would be in to be out, or visa versa.

But I would argue that has only limited potential impact for any given bond. Bank treasury buyers are just a part of the investor base. To the extent that they suddenly bid for the bonds that are unexpectedly included in tier 1, they will do this on a switch. The bond unexpectedly excluded will suddenly be available to everyone else. If supply/demand wasn’t so imbalanced, or if bank treasurers were the only buyers in town, LCR might have a relative value impact. In the current environment, probably not.

Again, not adding much value here. My advertising friend was unimpressed.

But if generically everything is going to get better, my friend’s question could be restated as ‘which covered bonds shouldn’t I buy?’ Which covered bonds could buck this trend and get worse?

Banks that go bust? Even formerly distressed sovereigns can now survive bank failures (as BES demonstrated so well). Combine this with the AQR (which has little incentive to surprise the market on the lenient side) and it seems like risks to the market are more likely to be idiosyncratic than systemic for the near future.

But, as BES again demonstrated, covered bonds survive, whether it be by the resolution directive or by the support of regulators for the covered bond brand.

My advertising friend recognises the value of brands. So does the covered bond market.
 
Protecting the Brand will be the topic of the 5th panel in Vienna, I hope you can make it.

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