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Foxes and Hedgehogs

17 June 2015
Richard Kemmish


“The fox knows many things but the hedgehog knows one big thing” – Archilochus

Analysis of the covered bond market used to be a delicate interplay of many factors: the housing market, bank credit, the strength of covered bond laws, supply forecasts, bund futures, sovereign spreads. Which is probably why it so often spanned the credit / rates divide. The best analysts in the golden years of innovation of the covered bond market (roughly from the first British, structured covered bond in 2003 until about 2007) were those rare creatures who were able to talk about both mortgage products and bund futures with equal credibility.

Of course the markets always had their hedgehogs, too. Syndicate managers (usually) who argued that this structural, credit stuff wasn’t of any relevance, all that matters was the absolute level of bunds. Morning briefings consisted of an indepth analysis of resistance and support levels of bund futures which we DCM officers had to go back to our clients to explain (we never did).

But it seems as if the market has come full cycle. Looking at the ‘in-depth analysis’ section of the Cover recently, the last three articles were about whether German government bunds were going up, down or sideways. Certainly this is partly because of the recent volatility in that market but I think it is part of a wider trend. Why is that?

Is it just possible that covered bond structures are now so similar that they don’t matter any more? Certainly the structures are still very different – legal entities involved, valuation methodologies, etc -  but details such as the EBA’s best practices proposal and the increasing exchange of technology between regulators means that the outcomes – in terms of the number of notches of rating uplift – are very similar.

Perhaps something similar is happening also to the probability of the covered bond structure being relied upon as a result of the resolution directive. Bank credit itself may be converging (as both regulations proscribe more closely what banks must look like and weaker banks fail) but the resolution directive has pushed the starting point for covered bonds two or three notches higher, therefore less relevant.

These are theoretical points. Spreads have compressed but this is mainly ‘beta compression’ – wider spreads tighten more than narrow spreads in a rally – as a result of the technicals in the market. It is impossible to know whether investor opinions on the relative merits of, say, Finnish and Portuguese mortgage markets have really converged against this backdrop.

Another thing for the list of unknowns when the ECB stops buying covered bonds.

What of the foxes - the covered bond analysts who actually take the trouble to read the offering circulars rather than just look at graphs of bund futures? I suspect their skill sets are about to become relevant again in the new, innovative, but ultimately credit intensive jurisdictions that are emerging. New covered bonds from Turkey to Brazil may be the spur of a new golden age of innovation.

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