Covered Bonds: spreads firm, but getting closer to the red zone vs SSAs
Primary market
March EUR benchmark supply close to an all-time low: At EUR50.6bn YtD, EUR benchmark supply is c.EUR25bn (35%) below 2024 YoY. At EUR7.5bn, supply in March is at its lowest level since 2021, EUR7bn below the 10Y average and nearly EUR12bn lower than last year's figure. The game-changing German fiscal plans threw a spanner in the works in March, as rates volatility resurfaced and the primary market slowed down to digest the evolving macro backdrop in Europe. We expect higher supply activity in 2Q25 vs. 2Q24 after a quiet first quarter, during which issuers focused on unsecured debt issuance, although the market could also wait for further clarity regarding the latest round of tariffs imposed by US President Donald Trump.
March 2025 has been rather skewed towards non-Eurozone supply, with the Nordics (ex-Finland) accounting for two-thirds of the EUR supply via six benchmark prints, and two further benchmark EUR bonds from Germany and the Netherlands apiece.
Breakdown by country: At close to EUR15bn, German banks have issued the most covered bonds YtD, followed by French banks. Surprisingly, Norway and the UK are next, although banks in these countries tend to fund mainly in their domestic currency. In fact, Sweden, Norway and Denmark are ahead of where they were in 1Q24; Australia and the UK have also been more active this quarter compared to a year ago in terms of EUR benchmark supply. Other than that, the vast majority of covered bond jurisdictions (primarily the Eurozone, but also Canada) are lagging in terms of YtD supply compared to 1Q24 (France is down 50% YtD, just one deal YtD from the Netherlands, a 6Y paper by NNGRNV), except for Germany which has broadly matched the pace of supply.
10Y or longer covered bonds have comprised just 6% of YtD EUR benchmark supply despite the overall strength in primary market execution. As such, this phenomenon is in sharp contrast to early 2024 when long-end supply made a comeback.
Investor sentiment for covered bonds has remained firm. This has been evidenced by an uptick in coverage ratios of the rather limited number of deals sold this month, after momentum sapped in February, while NIPs have also been largely non-existent and 6-8bp of compression from guidance to final pricing has been sustained, in line with what we typically saw in the first two months of the year.
Secondary market
Spreads of covered bonds continue to perform, with a lack of supply being the main driver. At the index level, covered bond spreads have tightened by c.7bp YtD, driven by the rally that largely occurred in January and despite the burst of rate volatility earlier in March, with the shorter end outperforming. The decisive move in Bund ASW – although it has stabilised in the past week – has altered the relative value dynamic in euro bond markets, with EGBs and EUR SSA spreads coming under pressure. Tighter covered bond spreads are in contrast with wider spreads in EGBs and SSA.
SSA and covered spreads are converging. Banks are getting close to pricing covered bonds flat to or even through top-quality agency and sub-sovereign paper. The spreads of the tightest covered bonds – typically German, Nordic and Dutch paper – over the major European supranationals and German Länder are hovering in the single digits.
Non-EEA covered bonds look too tight vs. EEA-covereds: From a regulatory standpoint, core European covered bonds, which: 1) benefit from lower risk weighting; and 2) are eligible for LCR level 1 (vs. non-EEA covered bonds, which are eligible for LCR level 2), should trade tighter than their non-EEA covered bonds. Having said this, since mid-2024, non-EEA covered bonds have been trading tighter than French CBs. Currently, French covered bonds are 6bp, 7bp and 15bp, respectively, wider than Australian, UK or Canadian covered bonds, showing the higher share of the non-regulated credit-oriented investor base in covered bonds.
The spreads of covered bonds from the periphery have tightened considerably. Spreads of Spanish, Italian and Portuguese CBs are 7bp, 8bp and 11.5bp tighter YtD at the index level. And Spanish covered bonds are now trading at the same level as the iBoxx EUR Covered Bond index.
We believe spread differentials between covered bonds and SSAs/EGBs might remain compressed in a ‘structural’ fashion, going forward, although SSA/EGB valuations will clearly provide a ‘floor’ to covered bond spreads. Meanwhile, higher all-in yields and persistently solid relative value versus tight credit spreads offer support to covered bonds. We do not expect material widening pressure in relation to covered bond ASW spreads until the valuation ‘ceiling’ lent by senior preferred is lifted, potentially by macroeconomic volatility. In essence, we think covered bonds are in a sweet spot to outperform both SSA and senior preferreds in the current macroeconomic setting.
The credit market holds the key to further performance of covered bond spreads
The credit market holds the key to the performance of covered bond spreads in the weeks to come. We still do not think markets are priced for the elevated recession risk created by an intense trade war, with spreads close to post-GFC tights: as a matter of fact, a widening of US IG spreads 120-125bp (c.30bp wider) and HY to 400-425bp (c.100bp wider) within the next six months would price 25% odds of a recession scenario, which does not look unrealistic to us given the current backdrop.
Moreover, the negative reaction of Auto stocks and credit spreads implies that Auto tariffs were not ‘in the price’, despite the widespread pessimism surrounding the industry over tariff risks and other secular headwinds. The uncertainty surrounding trade policy has shrouded the outlook for global growth, and in the absence of clarity, we believe many investors have assumed an ‘escalate to de-escalate’ strategy as their base case. Other sectoral tariffs have also been threatened, in sectors such as copper, semiconductors, pharmaceuticals, and timber/lumber, based on President Trump's recent remarks.