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Family resemblances

14 October 2016
Richard Kemmish

I’ve lost count of the number of times that I’ve been told that if there is a soft Brexit, British covered bonds are worth the same as Norwegian and if it’s a hard one (meaning Britain does not join the EEA) the right precedent is Canada or Australia. The Norwegian comparison is usually made in a slightly more tentative way because of the obvious differences between the countries, banking systems, mortgage markets and covered bond structures of the two countries.

But the Canadian/Australian comparison is little better, both are similar to each other and to the UK in terms of their covered bond markets, their wider financial and legal culture and indeed, culture. The covered bonds are structured in similar ways, mainly under common law, with similar supervisory regimes, a lively dispute about over-encumbrance and its effect on other stakeholders, parallel viable securitisation markets and a similar attitude towards the probability of state aid for a failing covered bond issuer. And roughly the same language. All of which gives a false sense of familiarity and a false sense of security about the quality of the pricing precedent that they provide.

As an example, some of the analysts say that Britain should price in line with Canada rather than Australia because it is a G10 country (therefore covered bonds are repo eligible at the ECB, albeit with no additional credit for their being secured). As this is a relatively minor technical detail that will only effect a few investors and as the pricing of the two countries bonds currently are very close this feels like one of those cases where if you quote a number to a sufficient number of decimal places it must be true.

The over reliance on superficially similar markets to provide price benchmarks is a common problem in covered bonds – I remember the first Portuguese covered bonds being benchmarked to those in Spain. Whereas both countries have economies linked by proximity their covered bond laws, issuer profiles, house prices and approach to bond issuance were totally different.

This tendency is made worse by our current focus on ‘rates topics’, in particular regulatory treatment for investors and eligibility for central bank purchase programmes or collateral lists. When prices compress this much it’s as if credit or technical factors don’t matter anymore.

The robustness of the domestic currency investor bid for covered bonds, the rate of change in net supply, the basis swap to euros, the profitability of the banking system, the composition of the issuer community and the probability of a drastic house price depreciation are all at least as important as ECB repo eligibility to the pricing of these bonds, probably more so. And in all of these Canada, Australia or, for that matter, Norway are totally different and therefore totally ineffective benchmarks for British covered bonds.

I don’t know whether the net effect of these factors is that British covered bonds are better or worse value than those issued by their Canadian cousins. But I’m sure that it is very different.

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