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A Rare Exception

16 May 2018
Richard Kemmish

LBBW’s sterling covered bond was very successful. More importantly it illustrated some important trends that we will be seeing more of in the future.

In this column I don’t often write about individual deals. There are far too many that are heavily over-subscribed, price inside the initial price talk and are glowingly described by proud book-runners. As for the ones that aren’t – well it would be rude to write about them, wouldn’t it?

I am going to make an exception for the recent sterling deal from LBBW described in best journalistic cliché as a ‘blow-out’ – at £750mn it was the largest ever sterling covered bond from a European issuer. Why am I making an exception by talking about this one? Favouritism? Perhaps a little, but more importantly this trade demonstrated a few interesting features that could well become a sign of things to come.

Firstly, it was a floater (most sterling covered bonds are but I’m not going to let that stop me making my point). Why aren’t more covered bonds floating rate? Outside the sterling market, they are desperately rare.

The arguments for floaters in our fixed rate dominated market may be weak currently but are all strengthening. More of the underlying assets are floating rate (ok, that trend varies by country and plenty of new mortgages are short-dated fixed rate. Perhaps it would be more accurate to say that the average asset duration in Europe across Europe is falling).

More of the buyers are banks, particularly liquidity books, and therefore have a natural preference for floating rate assets. Whilst we are with the liquidity books, there is a clear benefit for a bank to buy liquidity assets issued by foreign rather than domestic banks – the liquidity will hold up better in a generic domestic downturn.

Eurozone interest rates are only going in one direction from now. The only thing worth arguing about is how fast? This is exactly the opposite of the trend for the vast majority of the modern history of the covered bond market, guaranteeing nice mark-to-market profits for all. Don’t want a bond that will be worth below par this time next year? Buy a floater.

Secondly, the LBBW deal didn’t need a cross currency swap – LBBW have lots of sterling assets. Swaps are expensive (increasingly so?), use up credit lines, and sometimes reduce a programme’s collateral efficiency. The more banks operate outside their domestic currency in their underlying business – which let’s face it, is an objective of capital markets union - the more attractive local currency funding will be to them.

Finally, perhaps most surprisingly of all, Brexit just wasn’t an issue. Chatting to LBBW yesterday they said that investors didn’t bring up the topic of the prudential treatment of these bonds after Britain leaves the EU. A lot of us have been spending a lot of time worrying about whether British covered bonds owned by EU investors and EU covered bonds owned by British investors will continue to benefit from lower risk weights and other benefits. Perhaps we are worrying too much?

For many reasons the LBBW trade may be a sign of things to come.

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