According to the recently released bond outlook, after years of stagnation, economic momentum and stable credit quality should push the EUR 2.5 tln covered bond market into net growth in 2019. Ratings will remain firmly placed in the AAA category thanks to stable, even improving, bank ratings.
Even if capital markets become more volatile and spreads widen on the back of negative headlines or rising political or geopolitical tensions, Scope Group rating agency expects the stable credit profile of covered bonds will make them a preferred investment.
“High credit-quality covered bonds will provide investors with pockets of stability – at a time when markets and credit quality might reach a turning point,” said Karlo Fuchs, head of covered bonds at Scope and author of the 2019 Outlook.
Scope outlines a number of factors that will support increased covered bond issuance. These include upcoming covered bond maturities, the winding down of the ECB’s covered bond purchase program, as well as continued growth in house prices. Higher house prices will translate into higher mortgage lending volumes, which banks will look to refinance through covered bonds. Preparations for the post-TLTRO period will also be supportive for further growth.
“As the previous ECB backstop becomes less pronounced, issuers will need to provide more incentives, in particular higher premiums to investors to fully place their bonds,” Fuchs said. “Positive spreads in 2019 will pull real-money investors back to covered bonds in 2019.”
ESG-labelled covered bonds will gain further momentum in 2019 and issuers could use labelled issuance to substitute for lower ECB activity.
“With the ECB backstop waning, we expect ESG-type covered bonds to become a useful instrument for issuers to attract additional and often less price-sensitive investors,” said Fuchs.
From a credit perspective, recourse to the cover pool will remain the least likely scenario investors will need to worry about, as stronger regulation and higher bail-in-able debt levels will increase the distance to regulatory intervention.
Importantly, European covered bond harmonization will finally become reality. While minimum credit quality will increase, national differences will persist, so harmonization will not mean high and stable credit quality for all. European covered bond harmonization, scheduled to pass the European Parliament in Q2 2019, will introduce minimum common standards and this will become an important pillar of the Capital Market Union.
“We expect the first covered bond transactions under the harmonized European legal framework template to appear at the end of 2019,” said Fuchs.
Once the parliament has approved the principles-based EU covered bond directive, legislators can pull out the blueprints for requisite amendments. The parliamentary timelines of member countries will then determine which country will win the race to become the first fully-harmonized jurisdiction and which issuer will consequently issue the first ‘premium’ covered bond.
“But just being a regulatory labelled premium covered bond will not guarantee highest credit quality,” cautioned Fuchs. “Knowledge around the ability and willingness of issuers to maintain a well-groomed and low credit and market-risk cover pool will be more important for achieving and maintaining high credit quality.”
In terms of covered bond alternatives, covered bond funding might soon see competition emerging. Bank treasuries are increasingly looking to senior preferred funding when trying to optimize funding costs. Senior preferred might be the instrument of choice when banks are looking to lengthen their funding profile or exchange TLTRO funding.
Since the split of unsecured bank funding into bail-in-able senior non-preferred and senior-preferred, the latter has emerged as an additional and cost-efficient funding tool. While spread volatility has not been tested during a crisis, senior preferred ranks between covered bonds and senior non-preferred.
“With higher spreads and ranking almost as high as covered bonds upon regulatory intervention, we see a strong competitor emerging,” said Fuchs. “Without encumbering additional assets and no dedicated management needed, the all-in maintenance costs for both instruments could even flip in favor of senior preferred.”