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Waiting for Munich: 1 The Bear awakens

15 August 2018
Richard Kemmish

Ahead of the Euromoney Covered Bond Forum in Munich in September, some thoughts on the topics that we will be discussing. Starting with the first panel: the Bear Awakens.

The fundamental problem faced by anyone who writes about the covered bond market for a living is that pessimistic predictions are inherently more interesting than saying that nothing will happen. And the covered bond market is extremely bad at providing a basis for pessimism. So what’s with the awakening bear? 

A bear market is one where prices go down. Rates can’t get much lower so eventually bond prices will. But in a market that spends very little time thinking about cash prices and all of its time discussing spreads, that is a pretty tenuous definition of a bear market. Fortunately (for the title), spreads are going wider too. With the end of QE, an increase in net supply and a load of investors having checked out in response to negative yields, it is pretty clear what spread’s direction of travel will be for the next few years, if not the magnitude of the widening.

But even spread widening could be argued to be just part of the circle of life, hakuna matata. If all credit spreads widen then your market will widen according to its beta. So again, hardly a justification for bearishness.

One basis for an ursine view of the market’s future is that beta. I’ve always worked on 0.4 based on the average ratio of covered bonds to unsecured spreads over German government bunds (and I’ve just taken the five year because I’m too lazy to duration adjust it). But this 0.4 could start to increase – which would fundamentally threaten the size of the covered bond market as it becomes a less useful funding tool.

The problem lies in senior preferred bonds. My calculations of the covered bond market’s beta have, without knowing it, always assumed that the senior bonds in the calculation are un-preferred. Preferred senior bonds, by virtue of their bail-in exemption and the bank recovery and resolution directive might just be a bit too good for their traditional spread relationship to covered bonds. Still more expensive funding for a bank, but after you factor in the treatment of covered bonds in net stable funding ratios, the cost of over-collateralisation and the sheer hassle of setting up a programme, senior preferred starts to look attractive.

Another justification for bearishness could be credit. Of course, we all know that covered bonds don’t have credit losses. But they do get downgraded which can generate market losses. Why would I worry about that at a time when according to rating agency data upgrades outnumber downgrades so heavily? Simple answer: house prices. I have heard some very eloquent defences of these levels and their long term sustainability. Of course covered bonds have excellent techniques to protect themselves from this risk as was so well shown in for example, Ireland and Greece but even so. 

If I were to go against my nature and be even more pessimistic about the covered bond market I could argue that the combination of a lack of diversity in the investor base and the ratings cliffs embedded in the regulations are a problem waiting to happen.

Are there other reasons for bearishness? We will have to wait until the panel in Munich to find out.

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