Interest in covered bond markets has increased this year due to a number of factors: 1) spreads vs. swaps continue to be near record wides; 2) yield levels still look compelling; 3) liquidity in the market has improved with strong supply and the ECB stepping back from the market; and 4) investors are going longer duration after preferring shorter tenors for much of last year. As a result, real money investors returned to the covered bond market in 2023, and we see credit investors being more focused on the product in 2024.
The new ECB operational framework unveiled in March will not impact the ongoing covered bond supply and demand dynamics. The MRR was kept at 1%, so EZ banks will not suffer a negative impact on their LCR ratios. Lowering the MRR / LTRO rates by 35bp to the deposit rate +15bp from September should not impact the supply of covered bonds, as this is 3M LTRO funding which is not NSFR eligible. The structural bond portfolio and the timing of structural long-term credit operations, as well as design, are still unclear and too far in the future to be relevant at the moment. Moreover, in our view, the former is likely to focus on EGBs and SSAs, while the latter tenors would likely be in the 15-18 months area, so it is NSFR eligible, but with associated tenors and financing cost much less attractive than the TLTRO III.
With the ECB stepping back from the market, the credit component is back in the asset class. While bank treasuries have been more selective overall and more focused on shorter tenors, as they have increased their exposure to SSAs in longer tenors, above all it has been asset managers (AM) that have become more active, with existing accounts buying more while new investors have also discovered covered bonds. With real money accounts looking to add duration, demand has also been strong along the length of the curve, with banks focused on shorter tenors and asset managers going big in the 7Y-12Y tenors and Southern European deals. As expected, IC/PFs have increased their presence in long-tenor core covered bonds.
The increased presence of real money accounts will further contribute to the liquidity in the asset class, as bank treasuries usually buy covered bonds on an ASW basis for their LCR books, and they are mostly buy-and-hold unless extreme relative value dislocations vs. EGBs and SSAs materialise.
Covered bonds is an asset class that benefits from a combination of higher yields and macro uncertainty. We expect a number of investors to gradually switch their SP/SNP positions into covered bonds, largely in order to adopt a more defensive stance and take advantage of very attractive relative spreads vs. govies and SSAs.
We expect 2024 issuance for the remainder of the year to be lower than in the same period in 2023, as loan origination continues to decline while deposits remain stable or are even registering inflows. The pace of supply moderated in February after the busiest January (EUR41.5bn) since at least 2012, but it has picked up again in early March. As of 15 March, YtD issuance in EUR benchmark format amounts to EUR73bn, dropping slightly below the strong volumes in the corresponding period in 2023 of EUR81bn, with a positive net supply YtD of c.EUR30bn. There are low redemptions in March and April 2024 of less than EUR20bn.
We expect lower YoY covered bond issuance in 2024 of EUR160-170bn (c.EUR-equivalent 210bn: GBP25bn and USD15bn) vs. EUR192bn in 2023, driven by several factors: i) the redemption volume will fall from EUR126bn in 2023 to EUR114bn in 2024; ii) the TLTRO redemptions will be significantly lower in 2024 compared to the last twelve months and should amount to c.EUR450bn, and the significant jump in volumes in 2022 and 2023 across senior and covered bonds have prepared the banks for TLTRO repayments; iii) mortgage lending volumes have fallen significantly in 2023 and early 2024, and will likely remain low in 2024 due to the sharp rise in mortgage rates, although the dynamics of deposits and the covered-senior spread gap will also play a significant role.
In any event, net supply will remain strongly positive in 2024 for the third straight year, at c.EUR50bn, although down by c.EUR15bn vs. 2023. Accounting for the post-CBPP3 QT, the positive net supply will be c.EUR80bn.
Reopening of the long-end is underway: in stark contrast to 2H23, when most EUR covered bond transactions priced were in tenors between 3Y and 5Y, we have seen a successful reopening of the long-end. Almost 60% of this year’s new issuance have had maturities of seven years and more, while less than a quarter had maturities of less than four years. Covered bond investors have a need for longer duration following two years with mainly short-dated issuance, as issues up to the six-year tenor accounted for c.70% of the total in 2022-23.
After navigating through the financial stability concerns in March’23, the average SP-covered bonds gap now stands at 42bp (from 53bp as of YE23 and 65bp at YE22), and 60bp (from 78bp at YE23 and 115bp at YE22). As for the SNP-covered bond gap, this is now tighter vs. the average spread gap since 2017 of the two types of senior financials debt vs. covered bonds. If the covered bond-SP gap is below the 60-70bp mark (the risk-weighted gap between an AAA-rated covered and a single-A-rated senior unsecured), it is probably not worth using collateral and additional balance sheet encumbrance.
Market contagion to the rest of the EUR covered bond market related to the volatility in PBB and AARB has been negligible so far, although YtD German and Austrian covered bonds have underperformed the rest of the market on an index basis.
Needless to say, the covered bonds from Pfandbrief issuers with a higher share of CRE loans of 80% and more in their cover pools, such as Aareal Bank, Deutsche Pfandbriefbank, and Hamburg Commercial Bank, tend to trade at much wider spreads over swaps than covered bonds with lower shares of CRE loans in their cover pools. On the other hand, some Pfandbrief issuers with limited CRE exposure in their cover pools, below the 10% mark, such as DB, Commerzbank or ING DiBa, also trade at the tight end of the Pfandbrief spectrum.
Peripheral covered bonds remain in (very) high demand, as seen with the last two Portuguese issuances, the 6Y BPI (5.7x oversubscribed) and the 3Y Novo banco. The latter c.EUR5bn book is the joint largest in euros so far YtD, with a bid-to-cover ratio of 9.8x.
Spreads-wise, and excluding the relative value in long-tenor core covered bonds vs. supras in the EU, covered bond spreads are still a compelling proposal, not just for rates but also for credit investors. If the current risk-on mood continues, we see covered bond spreads tightening in line with the market, as we see the repricing that has taken place in the last 18 months as largely complete, particularly in the belly of the curve. If there is a negative change in the backdrop, covered bond spreads should outperform the rest of the credit market. On the other hand, SSA ASW spread curves are also far steeper than they are in the covered bond space, and a number of bank treasuries buy covered bonds in tenors out to 7Y but prefer either EGBs or SSAs for longer-dated investments.
The strength in the primary market can be explained, at least in part, by the increased engagement of asset managers (such as for the LCR-ineligible UBS covered bond) compared with the past two years, in light of the attractive relative value offered by covered bonds versus senior financials and non-financials. The strong metrics in the primary market should also benefit secondary market spreads, as the latter have not yet benefitted in terms of spread tightening. But we do not expect a material tightening of secondary spreads as the 5Y Bund ASW spread has tightened by c.45bp since mid-March’23 and is currently trading at around 35bp. This sharp drop is also weighing on the spreads of covered bonds, in addition to the stiff competition from the SSA-space in terms of relative value.
Although spread vs. swap is the main reference factor for investments, covered bond investors also look at spread vs. Bund, SSAs and credit (senior unsecured) to assess the relative attractiveness of covered bonds. Going forward, issuer quality and name recognition will remain among the most important drivers. Some investor fatigue is starting to creep in, with investors differentiating based on issuer credit quality, cover pool credit quality and exposure to CRE.
The short-tenors continue to perform well due to the high outright yields and attractive spreads vs. EGBs and SSAs. Investors who can go beyond 10Y would rather focus on SSAs at present, such as longer-dated EU instruments.
New deals are performing in the secondary market: this is a positive sign that the covered bond market has reached new clearing levels and that investors view the level of spreads and yields on offer as attractive.
As we stated in our 2024 Outlook, we think that overall primary market levels for maturities up to five years look fair. In the case of maturities of seven to ten years, the spread levels could widen a bit more, driven by high supply volumes. For maturities beyond the ten-year mark, the market has to find a new equilibrium as, at least so far this year, we have seen only five new issues (SOCSFH, BPCE, DKRED, CAFFIL and CARPP) with a tenor of more than ten years (the Bund-swap spreads have tightened by 70bp since the November’22 peak).