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The calm before the storm

22 August 2017
Richard Kemmish

Is the biggest threat to the covered bond market growing irrelevance?

Are we too smug? The covered bond market, and all who sail in her, survived the global financial tempest remarkably intact; new issuance, cover pool quality, rating transition matrices, reputation, investor base, whatever you want to measure, we come out looking pretty good. Hence the smugness risk.

But the first panel of the Euromoney Covered Bond Conference in Barcelona next month is titled ‘The calm before the storm’. An adverse shock to no matter which metric will be felt all the worse if it is unexpected. Where might it come from? And how real a risk is it?

Much has been written about the end of the bond rally after - depending how you measure it – circa thirty years. According to the Bank of England it is the longest bond rally since 1558 (you’ve got to love the Bank of England). Whilst a rate reversal will hit every bond holder, those holding covered bonds might feel the blow more keenly thanks to the typically higher duration of covered bonds and the historic lack of mark-to-market volatility caused by credit spread movements. We are just not used to losing money.

But rate movements are an obvious risk. Credit losses less so. In fact they warrant an entire other panel in Barcelona so I will return to that in a different post.

If loss, credit or rates, is one oncoming threat, a loss of our identity as a market is another. Ours is a gated community – the legal protection of the various national versions of the phrase ‘covered bond’ has been added to by the phrase ‘covered bond label’ and all that implies.

Newcomers, whether they are from Canada or emerging markets have always approached the market with a degree of deference to our rules and mores. This is not sustainable. New issuers from emerging markets may have to follow the European model - we won’t buy their bonds otherwise, but can you really expect American or Chinese covered bonds to defer to our two century-old habits? Similarly for other types of dual recourse instrument whether regulated (ESNs) or not (take your pick).

Closely allied to the forthcoming crisis of identity is a crisis of reputation. One day a covered bond will default. What will happen next?

But perhaps, just perhaps, the biggest, least obvious threat to our market’s well-being might not be from a storm at all. With senior preferred debt being bail-in immune, de facto, if not de jure and with many issuers increasingly having the credit profile of regulated utilities, spreads between that paper and covered bonds have been compressing. Without the added ‘hard’ expense of establishing a covered bond programme – ever increasing as legislation imposes more onerous requirements on the programme – and the ‘soft’ expense of over-encumbrance, senior unsecured debt is an increasingly competitive alternative for many banks.

From the other direction, Securitisation 2.0 – behind schedule and over-cost but here finally – might also represent a more cost effective alternative for corporate treasurers. Its relative benefit is a direct function of the risk weighting of the underlying assets and the regulatory capital ratio of the issuer – both of which are rising.

Is the biggest threat to the covered bond market growing irrelevance?

I look forward to hearing the panellists' thoughts in Barcelona.

The Euromoney/ECBC Covered Bond Congress will take place in Barcelona on Thursday 14 September. For more information, please visit the event webpage here.

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