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What is normal?

21 August 2017
Richard Kemmish

I am getting quite annoyed at the number of people who have pointed out that BBVA and CFF now trade in line with one another (at some maturities at least) as evidence that pricing in the covered bond market is distorted.

Let me make some things clear. Firstly, I do believe that pricing in the covered bond market is distorted, I just don’t think that this is evidence of it. Secondly, I have great respect for both entities – they are both exceptionally sound credits, responsible issuers and have good cover pools.

I just don’t like the idea that an issuer from Spain and an issuer from France pricing at the same level is somehow proof of market failure. I think that this idea is predicated on the belief that prices should reflect sovereign risk factors and that, even in this more benign sovereign credit environment, the pricing differential between private sector bonds should reflect the pricing differential between government bonds. If it doesn’t, surely this is a result of the ECB’s purchase programme.

I’m not even going to try to defend the notion that the ECB is a price taker rather than a price maker and therefore doesn’t distort relative value. I think we’ve all gone past that stage now. But there are enough non-ECB buyers out there to react to any perceived distortions in relative value.

If it were universally agreed that French and Spanish covered bonds should price differently (ceteris paribus) the actions of the ECB should represent an opportunity – to sell the Spanish bond, buy the French and help to restore the appropriate levels of relative value.

Which suggests that it isn’t a distortion but that the market actually believes that a good Spanish issuer can price at the same level as a good French issuer. The market certainly didn’t think that previously, it focussed on the various ways in which the sovereign credit can adversely impact the covered bond credit. But not many of these ways are particularly important any more.

It used to be assumed that weak sovereign credit meant macro-economic weakness meant poorer cover pools. I never particularly accepted this argument – covered bond structures are far too good at addressing the risks associated with economic downturns.

Then there was the correlation of sovereign and banking system credit. This was never particularly strong in Spain – where the two biggest banks in particular are heavily internationally diversified – and has diminished as a result of banking union.

Then there is the big one: sovereign default causes bank default. This was always less of a concern in the Eurozone than in countries with currency sovereignty but the precedence of Greece and (whisper it), the recovery of sovereign credit quality in Spain suggest that this factor can be discounted.

The sovereign – covered bond credit nexus is weaker than any time since the crisis began. Let’s not pretend that this is a sign of a market distortion. Maybe it is even the new normal?

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