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Waiting for Munich: 4 Syndication and trading just got difficult

23 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. The 4th panel is where syndicate managers and investors get to have their say.

Criticism of the pricing of new covered bonds rapidly becomes criticism of the syndicate desks responsible for it. As an ex-DCM person myself, I am of course more than happy to abuse syndicate officers but if I am totally honest I have to accept that the correct pricing of a new covered bond is increasingly difficult.

So far the most vociferous criticism of the process has come from the investors. This is natural, they are a far more concentrated group than issuers (by number, geography and culture) and, as they’ve got the money, they feel that they should have the power. They also – and this is a gut feeling for which I have no statistics – have more experience. The average person buying a covered bond has been doing it for longer than the average person selling them.

Despite their structural advantage, I struggle with their main argument put forward by the investors – that the new issue process is too iterative and that syndicate desks use investor feedback to reduce pricing too much. The standard argument is that I gave you information on where I see fair value early in the process, you use this to reduce the spread on the bonds, leaving nothing ‘on the table’. This seems to me to summarise as: in the absence of perfect information on fair value, I want to monetise my better information by virtue of being a larger investor. Not really how markets are supposed to work.

Information on fair value is currently far less perfect than it used to be. The secondary market is illiquid, there is a supply/demand imbalance with one huge investor as a wild card, and the market abuse rules make the traditional syndicate process – anyone remember ‘price whispers’? – less effective. So, if information is worse, the premium demanded by bigger investors should be greater.

I’m sure investors in Munich will put it differently.

I think that this fairly longstanding argument is about to get a lot more important. As the ECB becomes a less important factor in the market, as net supply increases and with a much reduced investor base, spreads will widen. Nothing looks likely to improve secondary market transparency.

This has two implications. If spreads are widening, it is generally more difficult to assess fair value than when they are fairly static. Price data from a deal from the same issuer last month is no longer useful. Its more difficult to hit a moving target.  

Less obviously, but more importantly, the tolerance of an error is less. In a one-way market does it really mater so much whether the issuer or the investor gets that last couple of basis points? But when markets are moving wider, deals may fail if they are wrongly priced.

As credit differentiation becomes greater – spread differences by issuer, rating, maturity or jurisdiction – so to does the importance of the entire relative value construct. The old values for each variable – X basis points cheaper for Germany, Y basis points more for a conditional pass through – need to be fundamentally reassessed. Again, the new issue pricing process becomes more critical.

Does the old pricing methodology need some new thinking? Could we use auctions? Could syndicates publish two numbers – a new issue premium and a fair value assessment?

Looking forward to hearing the views of the syndicates and investor on panel 4 in Munich. 

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