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What is the biggest threat to the covered bond market?

18 October 2017
Richard Kemmish

Another poll at the Euromoney covered bond conference provided very split opinions on this topic. I’m not sure if that is reassuring: there is no one big obvious risk out there – or worrying: we don’t know what our own problems are.

Let’s take the answers in ascending order of scariness. Perhaps, surprisingly, the lowest categories of risk were, equally at 11% each, issuer defaults and adverse resolution outcomes (presumably due to arbitrary rulings of resolution authorities). Obviously these are closely related and can be summarised as ‘credit risk’. It is an incredible testament to how well covered bonds actually work in even the most stressed scenarios that 78% of the market have got better things to worry about than rocketing house prices, non-performing loan backlogs, arbitrary decisions of regulators, ultra-low profitability in the banking system, probable sovereign defaults....but if you aren’t worried about credit risk I am not going to try to persuade you otherwise.
The next biggest risk, keeping 16% of you awake at night, is irrelevance. The decline in issue volumes in the established markets might be behind that concern – covered bonds have not been a major constituent of bank funding recently. But to what extent is that sustainable? Or is it a temporary phenomenon whilst banks build up their loss absorbing capacity? If it is temporary, the irrelevance presumably comes from the other type of ‘senior’ debt – preferred, non-bailinable debt. Too safe, too tight a yield and altogether too much of a substitute for covered bonds without all of the structuring hassle and asset encumbrance that our favourite type of bonds need. Interestingly the rating agencies are a long way from agreeing that senior preferred and covered bonds are such good credit substitutes. I’m with them on that one.

Rising rates are the second biggest threat to our market. Obvious enough and discussed extensively already. I’m presuming that the reason that it’s a risk is a rates risk – your bonds are about to go down in value – rather than a credit risk – the mortgages are more likely to default. There could of course be a side order of volatility risk. Rate cycle turns are rarely smooth.

Over regulation

And the biggest risk to the covered bond marker, as voted by you the participants is.....over-regulation. 32% of respondents spend their days fretting about it. An interesting follow-up question would have been, which regulations in particular are you worried about? I hope not harmonisation – a separate poll found that only 11% of the audience thought that harmonisation was both unnecessary and potentially dangerous. Other candidates include Mifid II: are illiquidity, lower trading opportunities and having to pay for research your biggest concerns? Or perhaps it is the capital regulations, or even (outside bet) EMIR? Or perhaps it is the sum of all regulation that is the problem?

For me, the biggest risk, though, is bad maths – the risks identified in the survey added up to 101%.

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