Jumbo liquidity hit by a big freeze

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THE JUMBO COVERED bond market lives up to its name. At the end of June, the volume of jumbos outstanding was more than €600 billion. That’s roughly 40% of the covered bond market. And it is getting bigger. In the first half of this year, jumbo issuance set a new record, exceeding €78 billion, partly because new covered bond issuers gravitate towards jumbos.

The whole point of jumbos is, of course, that they are large. The first jumbo Pfandbrief deals in 1995 had a minimum size equivalent to €255 million. Today, jumbo Pfandbriefe must be at least €1 billion within 180 days of issuance, and the amount remaining in the market must not drop below that level.

But size is just a means to an end. The end is liquidity, and this also requires market making. So for a Pfandbrief to be a jumbo, a minimum of three joint lead managers have to commit themselves to quote two-way prices in lots of up to €15 million during trading hours. Bid-offer spreads range from five to 20 cents, depending on maturity.

For years, jumbo covered bond liquidity has been taken as read. But in July, some tax-exempt covered bonds tightened by five or more basis points on the back of demand from specialist investors and arbitrageurs and had to be tapped to ensure continued liquidity. Although covered bonds had been squeezed before, Christoph Anhamm, head of covered bond and ABS research at ABN Amro, decided to look more closely at the jumbo market.

Some bonds are more equal than others

The market-making commitment takes the form of a written agreement between lead and co-lead managers and issuer. “In the contract itself, market making was and still is meant to refer to making markets for investors only,” says Anhamm. “Over the years, it has been established that banks also make markets to other market makers.”

There is, of course, nothing wrong with doing that. Indeed, it helps overall market liquidity by enabling individual market makers to trade larger tickets. If a client wants to buy €60 million of a jumbo that one market maker doesn’t own, that market maker can call four other market makers to find the bonds.

“This is an important aspect of the provision of liquidity,” says Anhamm. “But it’s not necessarily what market making was meant to be for.”

The problem is that market makers’ agreements with issuers say that they are only required to offer market making while a bond is liquid. Liquidity is hard to define or measure precisely, but it’s not unknown for liquidity in 10-year jumbo covered bonds to drop so that, when they are traded in two or three lots, the price moves substantially. Then either an issuer taps, or a market maker stops market making.

Or do they? “Of the 624 jumbo covered bonds that have been issued, we have only seen market making stopped or interrupted officially in 20 to 30 of them,” says Anhamm. This is surprisingly low. When liquidity flows to the books of investors that don’t want to sell, bonds are squeezed and some market markers see the chance to squeeze others. “That’s been done quite frequently by some banks in a way that has caused smaller market makers to interrupt or stop their market-making activities, because it costs them,” says Anhamm. “We have seen squeezes in jumbos that are not liquid, predominantly because of market makers’ behaviour.”

Trading in €15 million lots, the most a couple of traders can trade in one call is €30 million. In a matter of seconds, the market can see that it is short a particular bond. “You need to start with five traders,” says Anhamm.

Few market makers are willing to call up an issuer and say they need to stop market making in that issuer’s bond. They think it calls their commitment into question. They worry that they will lose face, and lose mandates. “We call the jumbo market one of the biggest liquid markets in the world partly because for every single jumbo out there, there are three market makers,” says Anhamm. “Is that real liquidity? No.”

After grandfathered bonds were squeezed in July, ABN looked at outstanding jumbos and asked what would happen if it executed a ticket of €30 million or €45 million in the bond: would bid-offer spreads not move at all, move out by less than 2bp, or by 2bp or more? It found that about one-third of all jumbos were in the lowest-liquidity bracket.

If trading activity picked up, the proportion could drop to around 15%. But still, as Anhamm points out: “A pretty high proportion of the market is not as liquid as you think it is when you look at how covered bonds are marketed all over the world.”

Those who argue that getting bonds onto electronic platforms such as MTS guarantees liquidity need to think again. “If we stopped phone trading and traded everything electronically, I think the result would be a big surprise for market participants,” says Anhamm. “If every jumbo is on the system, and I just deleted each bond that wasn’t trading, then a substantially large number of bonds would disappear.”

Tapping bonds is the obvious solution, and Anhamm points out that until around 2001 between one-third and one-half of jumbo new issuance came in the form of taps. To avoid hitting a bond’s performance and upsetting investors, tapping could be more regular. Issuers could communicate their intention to tap through their lead banks’ sales forces. Anything more formal, such as including commitments to tap in bond documentation, raises the problem of how to define liquidity in writing.

Honesty is the best policy

Jumbo coverered bond issuance Jan to Sept 2005

Anhamm’s opinions are not widely shared. First, his findings are hard to verify, particularly at the moment, when plentiful supply in the jumbo market means less trading in old issues, which disguises any liquidity problem. And market conditions mean that bonds without explicit market-making commitments have priced flat to jumbos and outperformed them in the secondary markets.

Secondly, nobody disputes the importance of liquidity. But many market participants think that intermediary banks have such an interest in making markets that they will continue to do so. The July squeezes did not damage liquidity. In short, the system works.

“The market didn’t become illiquid [in July], but there was a lot of volatility,” says Richard Kemmish, covered bonds product manager at Dresdner Kleinwort Wasserstein. “But that was an aberration that affected a small number of bonds. The jumbo market is a highly liquid market. Any reputable market maker will make a market. There is a moral if not a legal obligation to, and frankly, that’s where we make our profits.”

Nobody argues that those bonds issued by some of the smaller agency borrowers that carry no explicit market-making commitments are illiquid as a result. “We make markets whether explicitly required to or not,” says one head of syndicate. “You have to if you want to be a player.”

Nor does a straw poll of investors reveal much concern. “We are fine with the liquidity of the jumbos, with their size and market-making commitments,” says Felix Blomenkamp, head of European mortgage-backed securities at Pimco.

Meanwhile, issuers still feel that they have the ultimate sanction. “When one bank pulled out of market making, it didn’t get any mandates from us for years,” says the head of funding at a prominent Pfandbrief issuer.

Privately, though, a handful of issuers recognize that market making needs to be re-examined. “I understand people’s concerns,” says a member of one treasury team. “The reality of a market-making commitment is you have to offer bonds at a tight bid-offer spread, and that means you are always nervous of going short and offering a bid that then chases its tail.” It’s hard to pin banks down on this. First, they can argue that it’s in nobody’s interests that they sit on a huge inventory of bonds. Secondly, as this borrower points out: “Some houses don’t give you a straight answer.”

If jumbos are less liquid than the market wants to believe, as Anhamm argues, it’s hard to work out what needs to be done. Issuers don’t want to drive banks out of market making. Liquidity benefits from having as many banks making as many markets as possible. They know that it’s unfair to ask banks to make a market that costs it money over the life of a trade. For now, banks will say that they take the pain in return for underwriting business.

But if we are moving into a rising rates cycle, issuers can’t do big deals that offer easy returns because rates are being cut every quarter. The logical move is to offer smaller trades that tighten. But investors want performance and liquidity. It will be interesting to see if the market-making system as it has existed for 10 years can give them both.   

Shake-up looms in covered bond mandates