Although it is unlikely that troubles stemming from US sub-prime mortgages will have any seriously long-term detrimental effects on the covered bond market, nervousness among market participants completely drained liquidity from the sector at the height of the crisis. Participants found a fig leaf to disguise the breakdown in trading in the decision by market makers (meeting via a conference call arranged by the ACI financial markets association) to triple bid-offer spreads in late August. Although this did stabilize the market, subsequent trading of covered bonds was minimal. "The decision to triple bid-offer spreads was a necessity, as all other markets are out of line," says a covered bond analyst.
But at least one senior DCM banker thought the decision was wrong. "Covered bond liquidity! This is a joke!" he says. "These guys got together via the ACI and said ‘there is a breakdown, let’s agree not to quote each other.’ But nobody is calling anybody – there is nothing happening. People are scared to quote their clients because they feel they can’t flip the stuff. All this forced market-making is bullshit..." According to insiders most big banks were not making real prices because capital was needed elsewhere, for instance proprietary trading desks. Similarly a lot of government bond desks are operating with minimal amounts of capital, hence why there has been so much price volatility.
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Pfandbriefe and OFs with lower spread volatility |
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Source: Dresdner Kleinwort Research |
From a spread-widening perspective, covered bonds have been a relative oasis. Unsecured financial spreads in Europe widened by anywhere between 60 and 90 basis points. For RMBS issues that figure is between 20bp and 40bp. Covered bonds, by contrast, have only widened by approximately 3bp. There is nothing wrong with the covered bond asset class, but there has been a large contraction in liquidity. This was also due, to a large extent, to significant volatility in swaps and Bund markets.
When the decision was taken to triple bid-offer spreads the objective was ostensibly to offset the impact of global market turmoil on covered bonds but the claim that market-makers wanted to continue to provide liquidity holds little water as the problem was not alleviated. "The covered bond market has always put high liquidity out as a huge plus," says one. "But at the moment that isn’t happening."
Issues postponed
While some issuers might have exposure to sub-prime mortgages, covered bonds themselves, especially those issued under a legislative framework, are not at risk. Still, both Nord LB in Germany and Washington Mutual (whose bonds lack a legislative structure) in the US had to postpone planned issues because of a lack of liquidity in the primary market.
Although it is widely assumed that covered bonds are among the safest products around, the fact that the liquidity in this market disappeared does not bode well. Like many other sectors, the covered bond market is quiet in late summer. Low liquidity might have been exacerbated by a general consensus in the market to wait and see what happens over the next month or two. Most market participants feel fairly confident that things will return to normal. In fact, some covered bond types feel that issuance could even be boosted by some borrowers cancelling their planned RMBS issues in favour of covered bond programmes, so as to take advantage of their superior safety in bearish conditions.
Safety in numbers
Although some would disagree with this, most seem to feel that even with wider spreads, the safety advantages of covered bonds over other products has increased during this period of increased volatility.
If the market does restart with similar issuance levels to earlier in the year, it will have to do so in a new economic environment, one in which there has been a re-pricing of the curve across all asset classes. Issuers will have to stomach a new premium even for covered bonds and investors might find the sector’s self-proclaimed liquidity somewhat lacking.