Introduction

    Forecasting price movements when markets are behaving erratically is a highly prized talent albeit one that very few people actually possess. Financial institutions are no exception, having been waylaid over the previous two years on several occasions whereby experts failed to price risks into their exposures following unanticipated events such as the surprise US presidential election and Brexit results. As a consequence, buyers, sellers and arrangers in the covered bond market are now asking more probing questions about the core risks facing their enterprises, expected or otherwise.

    A particularly charged discussion point in covered bond circles today is concentrated on whether the industry is adequately prepared for the implications of the European Central Bank’s (ECB) withdrawal from CBPP3 (the third covered bond purchase programme) which is expected to happen next year. Most market participants are, however, quietly bullish that the recovery in the covered bond market is not going to be suppressed by the ECB’s actions, as they believe supply, investor demand and spreads will stay strong in spite of any potential turbulence.1

    Positive regulatory drivers – including the EU’s Covered Bond Directive (CBD) – will also help tame volatility by creating a consolidated, cross-border supervisory framework for the sector, stimulating supply and establishing covered bond markets in those member states which presently do not have their own. In addition, the EU’s Sustainable Finance initiative could spur interest in green covered bond products, encouraging further innovation. HSBC looks at these key trends and developments and assesses their collective impact on the covered bond market.

    Covered bond supply returns

    Despite liquidity in the covered bond market drying up as a result of the ECB’s substantial asset purchases interspersed with the retreat of investment banks from market making activities,2 supply is returning with around EUR120 billion worth of covered bonds being issued year-to-date 2018,3 a figure that has exceeded a number of industry expectations. A large part of the market’s re-energisation is a result of banks attempting to frontload their funding requirements in the first half of 2018 as they sought to contain the risks of rising yields should the ECB scale back net purchases towards its year-end zero target.4

    Other factors have played a role in the resurgence of covered bond supply as well. The Targeted Longer Term Refinancing Operations (TLTRO) depressed covered bond issuance as banks – particularly in Spain and Italy – flocked to the ECB to access cheap funding.5 But the decision by some banks to repay their ultra-cheap TLTRO II loans, totalling around EUR740 billion of collateralised instruments6 to the ECB ahead of schedule could lead to a resumption of covered bond activity as financial institutions seek a deeper re-engagement with the term markets. As supply returns, investors will once again become more comfortable about increasing their exposures to covered bonds after the CBPP3 and TLTRO induced interlude.


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    The risk of distorted pricing

    The industry is all too aware the CBPP3 has heavily distorted valuations of covered bonds, and that a wind down of the ECB’s bond buying programme has the potential to impact pricing across the entire asset class. However, a poll conducted at the Euromoney/ECBC Covered Bond Congress in Munich in September 2018 found people were seemingly relaxed about covered bond pricing with the majority of those present predicting spreads will widen by only five to 10 basis points (bps) in the next 12 months.

    This worldview is holding sway partly because the process of scaling down the CBPP3 is not going to be an abrupt event, but a controlled and steady procedure in what will help alleviate adverse spread developments.7 Net purchases by the ECB are also expected to stop in 2019 although it will probably reinvest CBPP3 redemptions – estimated by HSBC to total around EUR22 billion in 2019 – well beyond that thereby augmenting market stability.8

    Creating a harmonised covered bond market in Europe

    Facilitating greater investment within the EU is one of the pinnacles underpinning its Capital Markets Union (CMU), of which the CBD is an increasingly significant subset. The CBD, which was announced by the European Commission (EC) in March 2018 is designed to deepen the covered bond market inside the EU, cognisant it is highly concentrated in only a few European markets such as Germany, France, Spain, Italy, Benelux and the Nordics. The rules also look to reduce regulatory fragmentation of covered bonds inside the EU9, something which has stifled the market’s growth and impeded cross-border investment.

    The proposals outline minimum standards for the EU covered bond market, although as the CBD is a Directive and not a Regulation, local supervisors will have a degree of autonomy in how they interpret and apply the rules. These standards will include the establishment of a common taxonomy for covered bonds; a regime for investor and regulatory disclosures; provisions around capital treatment of covered bonds, and basic supervisory requirements.

    In addition to removing some of the regulatory obstacles encumbering the covered bond market, the CBD could also help the asset class grow in countries where the sector is less developed or readily understood by institutions.10 A handful of experts even believe the CBD could be used as a blueprint to further develop the covered bond industry in third countries outside of the EU, most notably Australia, Canada or Singapore.

    Investors, the EC believes, will increasingly shift towards covered bonds drawn by CBD’s enhanced transparency and regulatory harmonisation. The cost economics may also be quite attractive post-CBD implementation, with the EC – perhaps a bit optimistically – forecasting the rule changes could facilitate annual savings of between EUR1.5 billion and EUR1.9 billion for EU borrowers.11 With volatility rampant in a number of emerging economies, rules such as CBD will encourage institutions to consider well-regulated covered bond markets in Europe as they search for higher quality assets.

    Encouraging growth in green covered bonds

    In 2018, there was a significant rise in the issuance of green covered bonds, namely bonds backed by assets which are considered to have a positive environmental impact. However, these instruments remain a very small fraction of the overall covered bond market.12 The drivers behind the growth in green products have mainly come from the investor community, as their own end clients are becoming increasingly conscious about sustainability and are applying pressure on financial institutions to adopt green business practices.

    The EU has also been very proactive in supporting the development of green finance. Initiatives to incentivise green mortgage lending are in train through the Energy Efficient Mortgages Initiative (EeMAP)13. Other schemes include the EC’s “Action Plan: Financing Sustainable Growth”, a reformist programme announced in March 2018 encouraging EU financial institutions to support a climate and sustainable development agenda.14

    Included within the Action Plan’s contents is a provision for a classification system on sustainability in what will also apply to green bonds.15 The regulators hope this classification system – along with other measures around ESG (environment, social, governance) disclosure – will enable clients to benchmark their sustainable investments more effectively, helping to promote flows into green covered bonds.

    The Future of covered bonds versus senior unsecured bonds

    Spreads between covered bonds and senior unsecured bonds have fallen due to the current yield-compressed environment.16 This has made covered bonds less attractive as a funding tool from an issuer perspective, while investors – in order to make returns – are being forced to look at assets with higher yields. Ultimately, the decision to invest in either covered bonds or senior unsecured bonds will primarily be influenced by pricing.

    With the latter being recently split between bail-in able, non-preferred debt and higher quality preferred senior unsecured bonds, investors are still looking for the right relative price levels for these three types of bank debt. The risk premium that investors demand for preferred debt should be determined by the creditworthiness of the issuer and the extent of the cushion provided by non-preferred debt and other bail-able liabilities.

    In the case of covered bonds, investors need to consider the favourable regulatory treatment in terms of the risk weightings allotted under LCR (Liquidity Coverage Ratio) and BRRD (Bank Recovery and Resolution Directive). Investors should also assess the double recourse character of these debt instruments so as to ensure they can obtain a preferential claim on the cover assets in the pool were an issuer to enter into insolvency.

    An optimistic future for covered bonds

    Covered bond investors have suffered from a lack of supply over the last few years, as both the CBPP3 and the TLTRO have seriously dented new issue volumes. Most observers believe the market dynamics and spreads in covered bonds will not be dramatically affected by the slow withdrawal of CBPP3, as investors increasingly step in and pick up where the ECB left off.

     

    1&8 Global Capital (May 30, 2017) Covered bonds in a post-CBPP3 world
    2 Financial Times (February 8, 2017) How the ECB’s purchases have changed European bond markets
    3-6 HSBC Research – Covered Bond Quarterly
    7&16 HSBC Research
    9-10 Norton Rose Fulbright (2018) Covered bonds
    11 Linklaters (March 2018) EU proposes new framework for European Covered Bonds
    12-13 S&P Ratings (June 26, 2018) What’s behind the rise in green covered bond issuance?
    14-15 Clifford Chance (March 2018) EU Sustainable Finance Action Plan – what you need to know
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