|
Covered bonds: solid ‘floor’ and ‘ceiling’ spreads help absorb primary activity with negligible NIPs Covered bond activity has been picking up in the last few weeks. The YtD supply of EUR benchmark is down 27% YoY, with a supply of c.EUR73bn (vs. EUR100bn by mid-May 2024). However, it is worth bearing in mind that by the end of May last year, we reached 70% of the full-year supply, and that this slowed significantly from June onwards. We are confident that 2025 will be a different story. The high volume of redemptions in 2026 (c.EUR157bn vs. EUR140bn in 2025, coupled with c.EUR60bn of redemptions in 2H25) should lead to a pick-up in issuance volumes in 2H25. Three factors explain the lower YoY volumes in covered bonds: a) mortgage lending volumes are subdued and have not yet picked up; b) given the relatively tight spreads of senior to covered bonds, issuers are focussing on senior and senior preferred in a scenario of relative stability; and c) the high activity in the retained covered bond format, mostly for term repo funding or for repo collateral, have boosted optimisation. We expect the dynamics in items a) and b) to shift gradually in favour of more covered bond supply in the medium term, as the deposits vs. loans dynamics in 1Q25 in Euro area banks are supportive of higher wholesale funding volumes going forward, while potentially wider credit spreads of senior preferred vs. covered down the road would mitigate the negative impact of item b) in terms of the supply of covered bonds. The solid performance of key pricing references in the SSA universe for covered bonds such as KfW (in the high teens vs. ASW in the 5Y and in the low 30bp in the 10Y) and German Bundeslander provides more breathing space for the primary levels of covered bonds. Healthy oversubscription levels (at or above 2x in most cases), despite the aggressive tightening from IPTs (-5/-8bp in most cases). We would say that the asset class spreads could be defined as fairly priced/somewhat tight, with obvious secondary performance opportunities becoming scarce, with the only exception being French covered bonds in the belly. Regarding the investor breakdown in the post-Easter deals, we see significant activity from Central Banks/OIs, which are still the major buyers of covered bonds, mainly from core Eurosystem banks, those from Eastern Europe, the Nordics, as well as Switzerland. This strength and continuity of demand has supported supply, particularly out to five years. Asset management (AM) demand continued to edge lower in April, as tightly priced new issues with limited scope for secondary market performance potential have led to significantly less appetite from this cohort. On the back of the de-escalation in trade headlines, we expect covered bonds to maintain their valuation versus SSAs as a fiscally expansionary Europe regains ground. The supported spread in terms of the performance of Covered bonds is explained by the stability in both the ‘floor’ spread (SSAs/EGBs) and the ‘ceiling’ spread (banks’ senior preferred). Regarding the latter, the spread differential of senior preferred to covered bonds is now 20bp tighter than on 7 April and is now at c.35bp at the index level, 10bp above the YtD tights seen in mid-February (25bp). In the same way, the SNP-covered bond spread gap at 56bp has tightened by 23bp from the wides of this year (79bp) and it is 18bp higher than the YtD tights (38bp in mid-February). The 10Y swap spread has returned well into negative territory in the -5/-7bp area, and although SSAs spreads have so far not been affected, we will keep a close eye on the trend in the latter, as we still see a potential widening pressure on covered bonds more likely coming from the ‘floor’ (SSAs) rather than from the ‘ceiling’ (senior spreads/credit markets). US-China headlines were better than expected, potential short-term widening pressure dispelled On a broader basis, and regarding the overall direction of credit spreads, also a key factor for covered bond dynamics, we acknowledge that the recent US-China headlines have been better than expected, mostly dispelling a scenario of an abrupt widening in credit spreads in the short term. As such, despite the fact that US activity growth is poised to slow in the coming quarters, it now looks more likely that a recession will be averted, and that US GDP growth will likely range between 0.4%-1.0% in 2025, with a slight recovery in 2026 and that the pick-up in inflation figures we will see in the next months should be manageable to navigate by the Fed, which is widely expected to stay on the sidelines in the remainder of this year. The main risk at the moment is a scenario in which the ongoing rally sputters out at a point when it becomes clear that the ‘easy wins’ are behind us and that future headlines are likely to begin trending negative with the re-imposition of some tariffs, a potential escalation between the US and Europe, and, of course, economic data starting to show the impact of slowing trade volumes. Moreover, we believe that scrutiny over the US’ debt/fiscal position will gradually increase, as we saw with Moody’s downgrade of the US credit rating from Aaa to Aa1, citing concerns over rising government debt. It is well known that the US’ fiscal picture is not good, with the fiscal deficit already running at 6.5-7%, even in good times, with the first iteration of the House version of the US tax bill adding several trillion USD to the 10-year deficit. The term premium for US Treasuries will continue to rise unless a successful effort is made to rein in ever-rising deficits. However, in our view, this is all manageable for credit markets in the near term. Provided that we can avoid an outright global recession, with the probability declining significantly on the back of these recent headlines, the impact on European ratings and default rates should only be modest. We could still be in for a choppy ride in the remainder of the year, but a short-term collapse has been averted. SSAs: in a good place due to ‘pent-up’ demand and conservative pricing SSAs are in a good spot due to ‘pent-up’ demand. The YtD supply in SSAs is approaching the EUR-equivalent 470bn mark, meaning overall SSA funding progress is around 50% of the target in 2025. Most of the supply has come from supras, while German and French agencies have tried to front-load their funding. The sub-sovereign segment is dominated by German Laender, which has seen EUR37bn priced YtD. Some issuers have already covered c.60% of their respective funding targets (KfW at 65%, EIB at 69% and German Lander at 55%, among others). Issuance has picked up in the last few weeks and we expect a lot of issuers to try to front-load their issuance by the end of June. The EU has completed 72% of its EUR90bn 1H25 funding plan and has EUR25bn left to do via one syndication and three auctions (one in May and two in June). As per the EU's latest investor presentation, the EU expects to issue c.EUR160bn per annum in 2025 and 2026. This means that after June, the EU's 2H25 funding plan should not result in any major surprises in terms of size (c.EUR70bn in order to achieve the EUR160bn target in 2025. With the introduction of the Eurex 10Y EU futures in July, we would expect the EU to start its 2H25 programme with a 10Y. SSAs in USD barely reached USD26bn in April vs. a historical issuance activity in the USD33-35bn range. Year-to-date (YtD) USD issuance amounts USD131bn vs. USD160bn, which is c.17% below the corresponding volumes in 2024 (as of 15 May 2024/2025). On the other hand, the YtD issuance in EUR is more than 70% higher than the USD supply, also exceeding the corresponding volume in 2024. In all the USD deals YtD, the spreads readjusted wider on an asset swap basis (ASW), albeit tighter on a Treasury basis (UST +7bp for KfW, the tightest reoffer spread over Treasuries or an SSA since 2021, in the same ballpark as the USD deals from CEB, IADB and NIB). Some investors are voicing concerns about the historically very tight spreads vs. Treasuries that SSAs are offering, although we see a scenario of very tight spreads vs. Treasuries becoming a structural one, as according to the US Treasury Borrowing Advisory Committee, approximately 33% of the US publicly held marketable debt will mature in the 12 months from April. |