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The end of the purchase programme: supply side

06 October 2017
Richard Kemmish

In my previous post I got a little sceptical about the market’s sanguine attitude towards the end of the ECB’s covered bond purchase programme. In particular I posited that the relative price inelasticity of demand for covered bonds argues for a wide price move being needed to attract investors back to the market to plug the hole left by the ECB.

But demand is half of the equation. What of supply?

For several years now the story of the covered bond market has been that overall supply is more or less constant but only because new issuers are making up for the declines in issue volume from the traditional issuers. Supply from the traditionals is sluggish thanks mainly to low overall balance sheet growth and a need to issue capital, or other debt, that can be bailed in (the TLAC or MREL rules).
All of these factors are more or less totally price insensitive, both in theory – TLAC needs to be issued no matter how much more expensive it is – and empirically - this incredible spread environment has not stimulated any increase in the use of the product. There will of course be some temporal shifts in supply – bringing forward issuance in anticipation of spread widening but basically the same total quantum of bonds in the market.

There is more supply coming – TLAC targets will be reached, loan activity will recover – but the new supply will not be anything to do with price.

Buy vs sell-side

One fundamental point about the covered bond purchase programme that we tend to overlook is that it is different for the buy-side and the sell side. For the buy-side it is one of many purchase programmes. The biggest alternatives to covered bonds for most investors are also subject to their own more or less parallel purchase programmes. On the sell side this isn’t the case. Only the securitisation purchase programme is an alternative source of funding for banks and this is small and quite niche. As long as covered bonds are cheaper than unsecured debt and more expensive than short-term or central bank funding, supply will be relatively unaffected by price.

Perhaps in the long term the increase in supply from newer jurisdictions might be influenced by the price differential to senior unsecured debt – the upfront costs of a covered bond programme must be smaller than the cost saving. But as most of the likely supply comes from countries with a far higher differential between the types of debt it doesn’t seem to me that it will be particularly sensitive to any but the largest spread widening.

So if both supply and demand are price inelastic (and if I remember my economics correctly, which is a bigger if) the sudden removal of one big buyer will require a very large price move for the market to reach equilibrium. That was why spreads tightened so much, I can’t see any reason why it is anything other than, at best, just as large a widening.

Sorry if that sounds pessimistic.

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