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Sovereign spreads

22 January 2016
Richard Kemmish

It is now an accepted fact that covered bonds can price through sovereign bonds from the same country within the Eurozone, not just Spain, Portugal, Italy and Greece, but also occasionally in Belgium and oh-so-nearly in France. But what about for issuers outside the Eurozone?

To answer that question you probably need to look at why it happens inside the Eurozone. Covered bonds are of course better credits than government bonds. They have better credit ratings, higher expected recovery values, more legal certainty in insolvency and, frankly who do you trust more – the average homeowner or the average politician?

But, for this better credit to actually filter through to pricing two things have to occur. Firstly you have to assume that the areas where covered bonds are worse than government credit aren’t that important when compared with those areas where they are better. For me the probability of a government taking actions that force a covered bond to fail is remote but probably the largest area of uncertainty.
Secondly, you have to assume that either a government bond default doesn’t necessarily cause a covered bond default, or that if it does the covered bond can still get a better recovery value.

The other links between sovereign credit and covered bond credit are, I believe of secondary importance and we have mitigated against them. For example, economic crashes or a withdrawal of assumed tax-payer bail-out.

In summary, if we assume that covered bonds are allowed to do what they are supposed to by a failing government then the pricing is justified. Clearly that is a stronger assumption within a single currency zone and when banking supervision is standardised, or in some cases centralised. No-one ever questions an American credit pricing tighter than the state is based in.

But does this apply outside the Eurozone? The rating agencies think so – a bond can be rated above the government. Securitisations are in Turkey for example – but (as far as I know) only when they are secured on payments that are made off-shore.

For me though the possibility of an EM covered bond pricing inside the government curve relies on two things: firstly, the probability that the failing government will uphold the rule of law and not force private sector contracts to default, either directly or, for example by imposing exchange controls on resident structures. Emerging markets investors are used to looking at topics such as governing law and jurisdiction (even in default the government can’t change English law. Except the English government, obviously), transfer and convertibility language in ISDAs and government policy in default.
Which leads to my second point – can covered bond investors learn from their emerging markets colleagues? To reiterate a point I’ve made before: emerging market covered bonds are about selling emerging markets to covered bond investors, not about selling covered bonds to emerging markets investors. The latter doesn’t work. But the former relies on covered bond investors learning some new credit skills.

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