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Time to get over credit?

22 February 2016
Richard Kemmish

The discussion of the spread widening of covered bonds through the crisis was the starting point for the recent EC consultation. It’s a sign of how far we have come in recent years that it was a given that this widening must have been about credit risk, therefore the appropriate regulatory response would be to improve and standardise the credit-worthiness of the underlying assets. It didn’t even need to be stated, it was obviously about credit.

Given the youth of many market participants (how old does that phrase make me sound?) and the one big idea that has dominated our thinking since 2007 it is perhaps understandable that we think entirely about credit as the driver of spreads.

It was not always thus. In the early 90s credit was largely a back-office function (can we get a trading line please?), currencies and rates were the only things that DCM people spoke to their clients about (should we issue in Belgian francs or Dutch Guilders)?

Spreads were largely driven by liquidity. So the illiquidity in the pfandbrief market before the introduction of the concept of ‘jumbo’ pfandbrief was a major concern. Spreads over bunds widened from 30bps to 60bps, some investment bank researchers predicted that they would widen to 100bps as long as pfandbrief remained the market that was ‘easy to get into, difficult to get out of’.

Then the problem was solved: jumbo pfandbrief were invented along with market making rules, maximum bid-offer spreads and minimum ticket sizes (25 million Deutsche Marks, it seemed like a lot then).  Notionals got larger; traders got busy. My favourite prediction from that glorious time was that within 10 years pfandbrief with a notional of under €5bn would become a rarity.

And spreads tightened, the next time they widened it was because of credit, not liquidity.

My point though is not nostalgia.

No major credit concerns, no secondary trading, wide bid-ask spreads and a structural asymmetry – sound familiar? Admittedly that asymmetry is now the other way – covered bonds are now the market that is ‘easy to get out of, difficult to get into’ thanks to the ECB’s distortion of primary allocations – but comments from analysts about the lack of liquidity in the market undermine the bond’s eligibility for liquidity buffers, and potentially the rational for much of the buying by other investors.

I might be being overly optimistic to suggest that there aren’t any credit concerns left – but clearly they are diminishing rapidly as covered bond technology improves – whether it be legal convergence/harmonisation, common supervisory standards or industry led disclosure standards. Recent conversations that I have had with investors suggest to me that they are starting to worry far more about liquidity than they are about credit and I, for one, can only see that trend continuing.

Is it too much to suggest that we might be returning to pre-credit era drivers of spreads? If we are, it doesn’t look good for covered bond spreads.

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