As the European Central Bank (ECB) moves toward fully fledged quantitative easing, the recent performance of its existing programme to buy covered bonds and asset-backed securities (ABS) might give it pause for thought, market participants say.
Having launched its bond-buying strategy in October, the central bank would have hoped to have substantially expanded its balance sheet and injected confidence into markets that have struggled since the financial crisis. On both counts it has failed.
| The actions of the ECB in buying covered bonds and tucking them away in its balance sheet is a potentially distorting factor in the secondary markets|
In its most recent report, the bank’s assets totalled €2.16 trillion, compared with €2.05 billion when the asset purchase programme was announced. Some progress, seemingly, but the asset purchase programme’s contribution has been negligible, amounting to just €33.1 billion in covered bonds and ABS over the past few months. The bank aims to expand its balance sheet to €3 trillion.
“From the perspective of trying to fill in that trillion euro hole, the purchase of asset-backed securities and covered bonds has been a drop in the ocean,” says Gareth Davies, head of European ABS and covered bond research at JPMorgan. “There have also been some malign impacts which could do longer-term damage to liquidity and pricing, and may be a sign of how things could go for corporate bonds.”
From the moment the ECB announced plans to buy ABS and covered bonds in early September, price action in the securities reflected the presence of a new and powerful buyer in the market, with spreads moving sharply tighter.
In September, average covered bond spreads narrowed around 5 basis points, and the trend was reinforced in October when the central bank published details of its plan, specifying that the purchases would continue for at least two years and in unlimited amounts.
In addition, the bank said it would buy a broader range of covered bonds than in its previous two programmes – launched in 2009 and 2011 – bringing the total amount eligible to around €545 billion, or nearly half the publicly placed market.
By late October, as the ECB made its first secondary-market purchases, the spread of European covered bonds to their non-European counterparts had tightened by 10bp, a sizeable chunk for securities that seldom trade wider than 30bp over mid-swaps.
From an issuer point of view, tighter spreads represented excellent news, and banks across Europe wasted no time in printing deals.
“From mid-October to mid-November, we saw a decent flurry of euro-denominated bonds,” says a London-based banker involved in some of the transactions. “The first one was from Nordea Bank Finland and the central bank put in a decent order and got around 10%.”
In the Nordea deal, the central bank in the event asked for a bigger slice of the €1 billion 10-year note, the banker says, but told the issuer it wanted to be treated like any normal real-money account. The Nordea team had subsequently telephoned the bank to say it had long-term investors it did not want to let down, an explanation accepted by the central bank, which settled for its 10% share.
Unfortunately the moderation was short-lived, and over subsequent weeks a new dynamic emerged that saw long-term investors receiving lower and lower proportions of the distribution.
“Once we saw the peripheral Italian and Spanish banks coming in, secondary levels were moving tighter and the ECB allocation got bigger and bigger,” says Peter Mason, London-based head of FIG DCM, EMEA at Barclays. “The driver was that we effectively had the investor community saying spread levels were too tight”.
As investors sat out, coverage levels fell, and in late 2014 they ranged from 1.36 times for German mortgage bank Heslan to as low as 1.1 times for France’s BPCE.
Just a few weeks after Nordea, Germany’s Helaba printed a €1 billion transaction in which the central-bank allocation rose to 63%, with the deal pricing at 15bp through mid-swaps. Seven-year deals from Sweden’s Stadshypotek and Norway’s DNB Boligkreditt priced at swaps minus-2bp and minus-3bp respectively.
When Finnish specialist credit provider OP Mortgage Bank came in late November with a €1 billion 10-year deal, investor appetite had all but evaporated. Syndicate bankers struggled to fill the order book, and the issuer paid a relatively generous swaps plus-4bp.
A few days later, Ireland’s AIB pulled a proposed 10-year deal and effectively shut the market.
"The ECB programme drove prices to a level where many investors were not interested,” says Tim Michael, London-based head of financial bond syndicate at Citi. “The spate of underwhelming deals in November last year was the culmination of a period in which the ECB became an increasingly important player in both the primary and the secondary market, and crowded out much of the traditional investor base.”
Secondary-market activity fell sharply soon after news of the ECB programmes reached the market. Covered bond turnover in September was just €4 billion, around a third of the average over the previous year, according to Barclays. Secondary-market transactions accounted for 82.3% of the central bank’s purchases at the end of 2014, and poor liquidity continued through the end of the year, particularly in core markets.
The ECB’s hoovering up of the covered bond market came when markets were already thin. The €82,636 million euros of bonds sold in 2014 was the least in five years, as banks trimmed balance sheets and opted for cheap loans under the ECB's lending programmes. There was €95.4 billion of issuance in 2012 and €174.87 billion in 2010.
“Given the decline in liquidity we are seeing in any event, it’s pretty clear that the actions of the ECB in buying covered bonds and tucking them away in its balance sheet is a potentially distorting factor in the secondary markets,” says Barclays’ Mason.
|The ECB has been nibbling at edges and what is frustrating is that the edges it is nibbling are those already functioning|
While covered bonds have taken much of the critical limelight in recent weeks, the ABS prong of the ECB’s asset-purchase programme has ticked along quietly – in fact so quietly that market participants might be forgiven for forgetting the programme exists. According to a report published on January 9, the ECB has bought just €1.8 billion of ABS securities since it commenced operations on November 21.
“The ECB has been nibbling at the edges and what is frustrating is that the edges it is nibbling are those already functioning, and not those parts of the market that could benefit most,” says JPMorgan’s Davies.
“Certainly we have seen tightening of spreads but the northern European market was fairly tight already and the main impact has been crowding out in my view. My definition of success would be a reopening of the peripheral markets – especially Spain – which have been effectively closed since 2011, and we have not seen that at all.”
As the European bank now considers extending its asset-purchase programme from covered and ABS to corporate and sovereigns, the indifferent and sometime hostile attitude of market participants might be a sign of things to come.
“In the corporate space you are talking about a larger and more liquid market, but it’s entirely plausible that we would see the same crowding-out issues,” says Davies.
There were around €855 billion outstanding of euro-denominated non-financial corporate bonds issued by euro-area residents in November, and €2.5 trillion of euro-denominated financial corporate bonds, according to the ECB. That is a larger market than covered bond and ABS combined, and might limit the liquidity and spread impacts of ECB purchases.
In its defence, the ECB might also point to events in early January, when the covered bond market seemed to emerge from its pre-holiday funk, with a flurry of deals from banks including BBVA, LBBW and France’s CFF.
In contrast to the deals offered at the end of 2014, the new transactions came with new issuance premiums of around 5bp, which, with the spread widening and perhaps some new-year money, tempted investors out of their shells. Coverage levels on the 2015 deals were at much healthier 1.4-times to 2.6-times levels, according to Société Générale (SG).
“There was a bit of a premium to secondary and people were incentivized to participate, which suggests that even if investors have been crowded out there is some cash for the market,” says Paris-based SG head of covered bond strategy Jean-David Cirotteau. “We don’t yet know how much the ECB participated, but they would have been there, probably taking 25% to 30%.”
Meanwhile, end-investors, who have benefited from the spread tightening caused by the ECB programmes, and would do so more if the ECB buys government or corporate bonds, are more sanguine than some of their sell-side counterparts.
“If you were long ahead of the programmes then you are going to be a big fan,” says Neil Williamson, London-based co-head of EMEA credit research at Aberdeen Asset Management. “Longer term, you are not going to like the fact that you get less yield, but if you are a benchmark investor the impact would be less of a concern.”
That more nuanced view is reflected by US-based Jim Caron, managing director at Morgan Stanley Investment Management, who has seen the impact of asset purchases on US fixed-income funds.
“Sure, there is crowding out, but remember there is also crowding-in to riskier assets, and that is what these programmes are trying to achieve,” he says. “From an investor point of view, the presence of a new and powerful buyer is, on balance, a pretty good thing.”