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The euro covered bond market is bound to shrink

23 November 2016
Richard Kemmish

It’s that time of year when covered bond analysts everywhere start to publish their predictions for issuance next year. It’s a fairly pointless exercise; the predictions are always wrong. Events – the big ones: defaults, central bank policy changes or inconvenient referendum results - always overtake the most precise calculations of funding needs and basis swaps. But covered bond researchers enjoy the exercise and theirs is otherwise a pretty dull life so who would deny them their fun?

For what it is worth, it’s clear that the covered bond market next year will be smaller than it is now for several reasons. 

The nationalisation of the debt markets shows no sign of abating. Ultra-cheap four year funding from the ECB will continue to make any private sector funding source look expensive. Of course this is only intended as a temporary measure, of course... The longer it lasts the more bank treasurers feel able to rely on it.

Similar schemes in other countries (the TFS scheme in Britain for example) are just as important for the size of the euro market, sterling covered bond investors need something to invest in, eurozone issuers might be attracted by the spreads. The ongoing uncertainty about the post-Brexit regulatory treatment of euro issuer covered bonds for British investors will (I hope and expect) diminish over the year, allowing Britain to become a net importer of bonds. Either the UK will signal its intent to join the EEA or the concept of mutual recognition of covered bond regimes will start to gain traction.
The relative value for issuers of covered and senior bonds as funding sources will probably compress. This is to some extent a function of low spreads everywhere (remember when a Spanish issuer could save 200 basis points by issuing a covered bond rather than a senior one?), only slightly offset by flatter yield curves (the basis point saving of issuing a covered bond is partially offset by the tendency of the covered bond to be longer dated).

But the real relative value equation between the asset classes is not so much about basis points but about regulatory treatment. In most countries senior bonds can be bailed in and in most countries most issuers need more of that sort of debt. Covered bonds take a back seat as we fill our bail-in buffers with senior. There are many complications of course: in countries where all existing debt is made eligible for bail-in by the stroke of a lawmaker’s pen there is no pressure to issue bailinable senior. Also banks who are globally significant have already had to put in place enough of this type of debt (under the TLAC rules) so the MREL rules will only influence the behaviour of the small and medium sized issuers. And, senior debt will be more prevalent and lower rated relative to covereds, so the spreads should widen again.

The cumulative effects of all of these factors is impossible to sensibly quantify (not that this will stop anyone). Its just the market will be smaller.

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