2025: a slow start as expected, but we expect issuance to pick up vs. 2024
The turmoil in Bund markets temporarily closed the covered bond primary markets in early March. Given that last year we saw a strong 1Q24, we are trailing 2024 volumes by around EUR30bn (EUR48.7bn vs c.EUR76bn during the same period in 2024), but we still see a much stronger supply in 2025 vs. 2024 in 2Q and 4Q. We expect the supply in 2025 to be more evenly distributed across the four quarters (we expect 2026 redemption pre-financing to also play a much bigger role than during the difficult and quiet 4Q we saw in 2024). We were also extremely unsure about the 2H in 2024 (political events, central bank policy shifts), both of which led to even more front-loading of funding in the first six months.
Oversubscription ratios have rebounded strongly, as expected, in 1Q25, with average ratios of up to 3.1x in March, 2.35x in February and 4.5x in January. NIPs in 1Q25 started at a high level, 6-9bp in the first deals of the year, but since mid-January the average NIP has been a mere 1bp, with a number of deals, including the bulk of French covereds, showing either flat or negative NIPs.
Factors that could drive up the covered bond issuance activity in the next quarters would be by improved mortgage origination dynamics, a growing issuer base, a gradual normalisation of the covered bond-senior preferred, a gradual decorrelation of covered bond spreads vs. Bund-swap/SSAs spreads and 2026 pre-funding.
Investor distribution shows the same pattern as seen in 2024, with slightly more buying by AMs
Looking at the YtD numbers in 2025, we see slightly more buying by asset managers, slightly less buying by bank treasuries (41% vs. 50% in 2023) and, of particular note, a jump of 3pp from central banks / official institutions (CB/OI). For the latter, we are talking about levels that are not quite as high as they were during the QE years, although we are increasingly seeing them become important again, particularly in shorter tenors. Pricing with a yield of more than 3% has certainly done the trick here, and we would expect to see more involvement from ICs & PFs now that the 3% all-in yield mark is achievable in tenors above 6Y.
On the one hand, banks and central banks / official institutions have been major players out to 5Y, for which the spread vs. SSAs and EGBs is crucial. On the other hand, real money accounts have, above all, been chasing the wider spreads at the long end but have also been happy to buy a wide AARB 5Y. As such, the spread levels vs. swaps below the MS+50bp mark are clearly less interesting for the second group. Both groups will continue to interact in 2025, in our view.
By investor location, we still see a further drop in buying from German accounts (down to 37% from levels as high as 48% in recent years). The lower demand from German accounts for some tightly priced German issues can be explained by the fact that relative value is more attractive in SSAs and that covered bonds are trading tight vs. the German Länder. There is less buying from France (understandably so with French sovereign bonds wider than many covered bond segments, Figure 25.b). In turn, we have seen more buying by Nordic and CEE accounts (which at least in the case of CEE corresponds to the aforementioned buying by CB/OIs) while UK accounts have remained above their long-term average despite a slight drop vs. 2024 levels. The more credit-oriented investor type in Southern Europe is finally following in the footsteps of UK peers and increasing activity in the asset class.
The comeback of the credit/AM investors was one of the most noticeable trends in 2024&2025, enticed by improving liquidity, high yields and the higher spreads on offer. The general perception is that covered bonds now have better structural demand, and even credit accounts are willing to consider the asset class on a more ‘permanent’ basis given its improved liquidity and valuation post-QE, as well as its distinctively lower volatility.
Covered bonds spreads resilient to the further negativisation of the Bund-swap spreads
Covered bonds (CBs) have made a strong start to 2025, despite issuers pricing deals on average 7-8bp tighter than IPTs, as order books are well subscribed and bonds are still performing in secondary. In our view, and due to subdued covered bond issuance in 4Q24 together with many investors’ expectation of high new issue premiums in the first few months of 2025, a considerable number of investors were probably underinvested in covered bonds at the start of this year. For those investors who might consider covered bonds as a ‘credit’ alternative, we find it convincing enough to look at the current, much wider spreads, of covered bonds, as senior preferreds offer an asymmetric risk-reward at this point, in our view, there is little room to rally further on any positive news but a lot of room to reprice wider on any negative macropolitical development.
By jurisdiction, Italian and Canadian CBs have tightened by 7bp, and French, German and Spanish covered bonds around 6bp. Although the spreads of French CBs have tightened by c.6bp since 1 January, they are still trading 15.5bp wider than Canadian CBs at the index level, 5bp wider than Spanish CBs and 8.5bp wider than Portuguese CBs. The “periphery is the new core” mantra remains intact.
High-quality single-A senior non-financial debt has underperformed covereds since April, and they now trade at a premium of c.40bp to covereds (vs. 9bp at the low point in April 2024). Conversely, the premium of senior preferred bonds to covereds has been declining since September 2023, stabilising around the 30bp area in the last quarters.
The Bund-swap spread tightened significantly in 4Q24 and once again reached uncharted territory as of late February-early March’25 with the 10Y Bund-swap at around -10/-15bp. We are now at the tightest spread between Pfandbriefe and Bunds in a very long time, approaching 30bp in the 5Y between Pfandbriefe and Bunds, and in the 10Y we are already below this level. We see this range as the new fair estimate structural spread between German covered bonds and Bunds, which in the 5Y would be in the 25-35bp range and around 20-25bp in the 10Y, which would only be around 10bp higher than the 15-25bp range in the 5Y and the 10-20bp range in the 10Y we see in other core countries such as Austria, Finland and the Netherlands.
In the same token, we also see a narrower spread gap between Länder and German covered bonds vs. the current 7-10bp, due to the differences in the supply picture. Across the board, we would see German SSAs and Pfandbriefe tighter vs. Bunds, although with KfW possibly moving into the high teens in 10Y and Länder into the low- to mid-twenties.
We believe spread differentials between covered bonds and SSAs/EGBs may well remain compressed in a ‘structural’ fashion going forward, although SSA/EGB valuations will clearly lend a ‘floor’ to covered bond spreads. As an example, the 10-15bp spread gap between KfW and covered bonds now looks to be enough to account for the differences in regulatory treatment vs. the 30-40bp gap in the past. As such, even though the tightening of covered bond ASW spreads may be restricted by SSAs/EGBs, we expect covered bonds to be more resilient than their rates comparables during episodes of rates volatility. This is when the differential credit component of covered bond spreads comes into play vs. SSAs and EGBs, although a further tightening of swap spreads would put meaningful widening pressure on covered bond spreads.
We see covered bonds becoming incrementally less sensitive to swap spread moves and that a tighter differential in covered bonds-sovereigns will become more structural going forward. In this regard, we see covered bonds trading tighter than their sovereign references in the 10Y tenor in countries such as France (0/-10bp), Spain (-10/-20bp) and Italy (-15/-30bp) and with a slight pick-up in the 5Y in all countries apart from Italy.
Despite the recent collapse in the Bund-swap spreads, we have not seen any widening in covered bond spreads to date, in stark contrast to what we saw with the spread widening in October-November’24. We see two threats for covered bond spreads (Bund-swap & SSAs) and one support (credit spreads), and we see the latter as a critical anchoring factor.
Rising rates yields driven by improved economic prospects (in addition to the increased supply) have been positive for credit spreads (i.e., tighter) to date. This makes sense to us, as we think a ‘one-off’ adjustment to yields on the basis of revised supply assumptions is a very different situation to the inflation-led rate moves seen in 2022, which were accompanied by a central bank hiking cycle. The fund flow data since 2H23 shows that investors have continued to allocate capital to high-grade euro during periods of rising Bund yields.
A deterioration in the US growth picture and escalating tariff threats are thus the main threats for covered bond spreads on the credit side. We think the likelihood of a recession is still low, but has clearly risen. Even if EUR IG spreads widen by 15/20bp from current levels they would still roughly imply a c.25% risk of a recession, based on a cycle tight of 85bp and historical spreads in excess of 180bp in prior recessions. There is a limit to how much better Euro credit can hold-up in the face of US credit weakness, before the Euro market itself becomes vulnerable to shorting.
In the same token, a sudden widening in EUR banks’ spreads due to the sector’s cyclical nature and heightened vulnerability to the expected global economic slowdown – reflecting investor concerns about the potential impacts on profitability and asset quality – would move the covered bonds spreads ceiling (senior preferred) up and hence push covered bond spreads to wider levels.
SSAs under pressure due to growing supply activity and the underperformance of swaps vs yields
SSA markets have come under renewed pressure with Bund-swap spreads collapsing even more. It is hard to put a floor underneath swap spreads at present. The high supply volumes of EU in 2025-2026 will continue to be negative for SSA valuations overall in EUR markets, especially at the long end.
The German version of Draghi’s “whatever-it-takes” is a gamechanger for the long-term macro outlook. Germany is sending a huge policy signal that it is going to boost its economy by fixing its infrastructure and is taking full responsibility for its security by reducing its reliance on the US. Germany was facing a potential growth trajectory heading towards zero in the coming years. Assuming 1% of domestic capex stimulus per year, paired with perhaps 1-1.5% more defence spending, including an ambition to enhance domestic supply, this would catapult growth prospects closer to an outlook for 1.5-2% growth from 2027 onwards, assuming no offsets from tariff uncertainty.
The European Commission’s ‘ReArm Europe’ plan for defence spending introduced by European Commission President Ursula von der Leyen and endorsed by the European Council held on 6 March could represent up to EUR800bn of incremental defence spending on paper in five main proposals, including both public funding in defence at a national level, as well as the creation of a new EU instrument (EUR150bn), established under Article 122 of the TFEU to provide EU member states with loans backed by the EU budget
We had initially expected more joint funding. However, the minimal size allows the EU to work with resources that have already been approved for the current budget and NGEU rather than having to make a new Own Resources Decision. The net EU supply would extend to 2029 from 2026 at the moment, and the size would still drop into a range of EUR80-100bn from the current EUR160bn. Other joint funding options can be tapped later should this prove necessary.
Regarding the funding impact for the EU, the issuer already announced that the new instrument will have no impact on its EUR90bn 1H25 funding plan. The 2025-2026 period is already expected to be pretty busy issuance-wise for the EU (c.EUR160bn bond issuance is expected in this period) driven by disbursements under the NGEU programme, but also other programmes such as lending to Ukraine as well as the refinancing of EU bonds and additional needs could add to this pressure.
In turn, should these additional funding needs be back-loaded into 2027-29, it would coincide with limited EU funding needs (refinancing of EUR45-50bn of maturities). The latter would be quite positive for the EU, as it would be supportive of the liquidity of its curve, as it would allow gross supply to remain in an EUR80-100bn range, the same issuance range as KfW.