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The Covered Bond Blog: Will you be coming back?

27 May 2015
Richard Kemmish

Investors are leaving us. Who wouldn’t given the double whammy of low interest rates in general and the ECB purchase programme pushing covered bond spreads tighter relative to, say, unsecured debt of the same issuer?

Should we be worried? I argued in my last post that the ECB must stop buying covered bonds one day but that day might still be a long way off. Those who expected the purchase programme to be quietly forgotten when sovereign QE started have been bitterly disappointed. So one day, whenever that is, we are going to need some new, private sector investors. Not a situation that we have seen for a long time.

Some of the first investors to exit the covered bond market in response to the ECB’s buying programme were not natural covered bond buyers. They were general fixed income investors who had taken a conscious decision to go long covered bonds and who enjoyed a very strong multi-year spread rally. A huge, price insensitive buyer in the market is just what you want when you decide that it’s time to take the profits and move on.

Presumably most of these investors will have gone down the credit curve into bank capital or emerging markets. But as the US demonstrated when they reached the end of their QE buying programme – the famous taper tantrum – these aren’t good places to be when rates are about to turn (incidentally, its now two years since the taper tantrum and we are still seemingly a long way off the first actual rate hike in dollars. Was it all about nothing?).

Will these investors return? I can’t see a fixed income product with duration and very tight spreads as being a good place to be either when rates start rising.

But these are the fickle investors who enter and exit the covered bond on a whim. Equally important are those who have to buy, whether because that is what their fund is for, because the regulators are forcing them to buy assets (for example to fill their liquidity ratio targets) or because they need collateral.

These investors seem to have been the worst hit by the ECB squeezing them out of the market. Presumably they are currently underinvested in covered bonds relative to where they want to be and will be looking to increase their exposure when the ECB leaves the market.

But just as some investors have abandoned covered bonds for more risk, some investors who have historically been invested in the government market have switched into covered bonds as a consequence of QE. These, the most credit conservative of investors will have spent a lot of time and effort getting credit lines for private sector bonds. Lines can get cancelled but when you have bought an asset class once, the second time is easier. 

One thing is for sure, the investor base post-ECB will be different from that which we are used to, with different knowledge base and views on relative value.

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