SSAs’ new clearance levels: EUR10Y new syndication last week at ASW+65bp with books of over EUR95bn for a deal capped at EUR9bn. Fair value estimates were at ASW+62/63bp. So business as usual for the EU, despite the most volatile Bund market since 1990.
A successful trade for the SSA market that enabled other deals to hit the market, such as Unedic’2033 EUR2bn social benchmark (0% RW, explicit guarantee from the French sovereign) at OAT+4bp (IPT OAT+8bp, 3.54% coupon, books EUR12.3bn, mid-swaps plus 80 area) and the city-state of Berlin (Aa1/AAA/-) going for a EUR 3.125% EUR1bn 10Y (Bunds+28.5bp) at MS+44bp (same level as IPTs, books above EUR1.35bn, around 4/5 bp wider than same tenor KfW), roughly 6-7bp wider than where 10Y Bundeslander were trading before the recent underperformance of Bunds vs. swaps. Last week SSA deals showed that SSAs/Länder have repriced wider in terms of ASW spreads, although the sensitivity to narrowing swap spreads has been lower vs. previous episodes of swap spread gyrations, such as in 2H24.
The strong performance of the credit/senior preferred asset class during the Bund turmoil, with a mild widening of 4-5bp at most during the latter period, prevents a further widening of covered bonds. As an example, senior preferred levels in the 7Y area are in a tight range of 90-98bp on an ASW basis amid most of the EUR banking space, thus barely 30bp above where the high-beta part of the covered bond market (including France) trades in the 7Y-10Y area.
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 lend a ‘floor’ to covered bond spreads. As an example, the 10-15bp spread gap between KfW and covered bonds looks enough now to account for the differences in regulatory treatment vs. the 30-40bp gap in the past. As such, even though 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.
Given that Germany is in the centre of the newsflow now, narrow inter-jurisdictional covered bond spread ranges may last a bit longer, although we still see some of the very tight jurisdictions these days, such as Portugal, at risk of underperformance should a sustained risk-off tone emerge due to macroeconomic volatility.
The differential credit component of covered bonds spreads is a relative advantage vs EGBs & SSAs in a context of deeply negative Bund-swap spreads in the 10Y area and supply pressure from EGBs. Thanks to this credit component, covered bonds would incrementally become less sensitive to both swap spread moves and the tighter differential in covered bonds-sovereigns.
Another anchor factor for covered bonds spreads is the higher all-in yields, with indicative iBoxx EUR covered bond yields having once again reached 3%. Higher all-in yields are supportive of spreads (vs. swaps) and this could be an opportune period to lock in higher yields. This would be particularly the case for investors who think 10Y Bund yields will eventually retrace from current elevated levels due to the offsetting dynamics of a potential tariff-induced economic slowdown vs. the current term premia concerns due to increased Bunds supply, which might be impacted also by the timing of this new supply or it could be diversified away into short-term -bills first.
Senior preferred spreads/credit markets are the ‘ceiling’ in terms of covered bonds spread valuations and spread differentials of senior preferred bonds vs. covered bonds have been in a broadly consistent decline over the last two years. Given that higher fiscal spending by Germany could ultimately be positive for generic credit spreads via a growth uplift and higher product yields (due to higher rates), there could also be a beneficial spillover into covered bond ASW spreads, given the asset class lies at the crossroads of the rates and credit spectrums.
To sum up, in the current context, with two (Bund-swap spreads, EGBs) of the traditional driving factors of covered bond spreads exerting a widening pressure, the credit component is the one that is anchoring covered bond spreads. Hence, a sudden widening in EUR banks’ spreads due to the sector cyclical nature and heightened vulnerability to the expected global economic slowdown reflecting investors' concerns about potential impacts on profitability and asset quality would move the covered bonds spreads ‘ceiling’ (senior preferred spreads) up and hence covered bonds spreads to wider levels.
All eyes now on the purported 2 April deadline for US reports on trade imbalances, where president Trump has already advanced that both broad reciprocal tariffs and additional sector-specific tariffs would be imposed. There is a limit to how much Euro credit can hold-up in the face of US credit weakness, before the Euro market becomes vulnerable itself to shorting and hence covered bonds spreads come under renewed widening pressure.
However, should macroeconomic volatility pick up meaningfully in the near term, we believe credit spreads would be naturally susceptible to underperform covered bond spreads. In aggregate, we think covered bonds – viewed as the ‘weakest’ rates product and/or the ‘strongest’ bank credit product – are in a sweet spot to outperform their comparables (i.e., SSAs/EGBs and senior preferreds).