Despite the relentless commentary of covered bond participants on the relative benefits of their product in times of financial stress, severe difficulties continue to hamper the market-making process, and the secondary market remains in virtual paralysis. Various measures implemented by such bodies as the European Covered Bond Council (ECBC) since the credit crunch, such as the tripling of bid-offer spreads and the splitting of the market into core and non-core jurisdictions, have not had the desired effect of reinvigorating the stalled market. Although some issues have enjoyed small measures of success in the primary market, most notably those from German Pfandbrief issuers, the market remains illiquid and trading of covered bonds in the secondary market is non-existent.
Of course, the covered bond market is not alone in this. All markets are at present facing difficulties. From triple-A rated government bonds through to high yield, almost every market is experiencing the same thing. But the difference with the covered bond market, as in government bonds, is that there is mandatory inter-bank market-making. The idea is that no matter what’s going on elsewhere in the markets, covered bonds should remain liquid in the inter-bank market. That way, the secondary market remains open. But this has not happened. While market-makers have been quick to insist that they are living up to their side of the bargain, it is clear that that is not entirely the case. The outdated practice of market-making over the telephone allows for people to be conveniently away from their desks at opportune moments, and the lack of electronic records of prices given means that in some cases it’s one person’s word against another’s when there is a disagreement over a price. The ECBC is addressing that particular problem with a plan to create a hybrid market-making platform to replace the telephone system, among other suggestions put forward by the industry, but even if the market-making process is tightened up and made more transparent, that will not necessarily get the traders interested again.
What has become clear is that covered bonds carry credit risk. The core markets blew up just the same as the non-core ones, and the question whether covered bonds are a rates product or a credit product is no longer a question at all. What that means is that improved market-making might not result in similarly improved trading volumes. Traders are taking their cue from how the wider credit markets are doing; as long as those markets are suffering, any measures implemented by the ECBC or anyone else in an effort to inject liquidity and reinvigorate the covered bond market will only enjoy limited success.
Covered bond bankers are beginning to realize this. At the ECBC plenary meeting in Milan last month, there was a lot of talking but very little in the way of definitive action. What the credit crunch has done is to show everyone that covered bonds do not behave the way people thought they did. One delegate in Milan likened covered bonds to a teenager, saying that the product is now entering the difficult years between childhood and adulthood. If that is true, it’s clear that covered bonds have a rebellious side, and are not going to do what they’re told just because they should.
