The announcement last month that the European Central Bank (ECB) is supporting the covered bond market with purchases worth E60 billion ($83.6 billion) has added further momentum to the covered bond market.
It's still not clear which products will benefit from the purchases and by how much, but market participants said that the market has already begun to indirectly benefit from the more positive sentiment the forward-looking program has brought.
"The ECB stance has actually reopened the market by rebalancing clients' interests and providing a backstop bid for covered bond holders," said Sebastien Gianfermi, head of SAS and covered bonds trading at BNP Paribas. "This has brought back to the primary market several clients that were staying on the sideline and waiting for such a signal to reenter."
The announcement, for instance, led to a significant narrowing of spreads in the multi-cedula segment of the market. However, at the same time, it caused renewed widening of bid-ask spreads and a renewed downturn in liquidity.
"It's true that we have seen a flurry of activity that we consider to be a direct result of the ECB announcement," said a spokesman at VDP, the association of German covered bond banks. "We have even seen some spread tightening."
However, Ted Packmohr, head of covered bond research at Dresdner Kleinwort, said that market participants might once again lose the feeling of a fair market equilibrium on the back of concerns that the ECB's purchases might create a distortion between individual covered bond classes.
"In this environment, dealers understandably come forward with defensive offers at best, hence the availability of bonds has further declined," Packmohr said. "Although in principle we welcome the action of the ECB, it has thereby robbed the market of some of the agility it had started to reacquire in recent weeks."
To be sure, the announcement of ECB purchases comes at a time when the market is just beginning to get onto its feet. The First Annual European Covered Bond Investors Survey conducted last month by the European Covered Bond Dealers Association (ECBDA) showed that investors, including asset managers, commercial banks, pension funds and other institutional buyers, continued to have appetite for covered bonds. Of the respondents, 64% were looking to increase or maintain their investment in covered bonds for 2009.
Results of this survey were completed prior to the announcement of the ECB buyback program. With an excess of E12 billion slated to come to market, issuance volume in May is comparable to pre-crisis months - and at much tighter spread levels compared to just a few weeks ago. As a result, issuance dynamics in the competing state-guaranteed segment appear to have cooled initially.
However, Packmohr said that the ECB's further pledge of support for the market will help place the banks' funding on a broader footing, which should also impact favorably on their credit quality. It will also allow the central bank to indirectly address the bottlenecks in lending policies from which the private sector is suffering.
Full details of the ECB covered bond program, which is slated to start in July, were announced last Thursday. The central bank has explicitly stated that it will target euro-denominated covered bonds. According to the central bank, bonds must be issued in the Eurozone in order to qualify for purchase, which means that British, Swedish, Danish, Norwegian and Hungarian papers would be excluded.
"However, it is important to remember that, under its general documentation, the ECB's definition of the place of issue does not necessarily relate to the headquarters of the issuing institution, but to the place of deposit or registration of the debt instrument with a clearing institution," Packmohr said. "This could enable issuers to get around their regional exclusion."
The limit of the purchase has been set initially at E60 billion, but market players said it is likely that the ECB will raise this amount. Packmohr also said that the ECB's statement that it wants to support the covered bond segment leaves room for outright purchases in the secondary market, similar to the Asset Purchase Facility of the Bank of England, where the objective was also "to improve the liquidity in, and increase the flow of, corporate credit by making purchases" in this segment.
"Should the ECB decide for such secondary market purchases, it would raise the problem that the ECB would be acting publically as price-setter and therefore reinforce spread differences between covered bonds of different countries, putting it in a politically awkward position," Packmohr said. He added that to be efficient, a combination of both a primary and a secondary market strategy could prove to be most advantageous for the ECB.
According to the ECBDA survey, investors would most like to see improved B2C and interdealer liquidity and transparency addressed in 2009. The lack of liquidity was cited as one of the main reasons for spreads on covered bonds remaining wide in the secondary market. "The ECBDA and its members have been actively working on initiatives to improve interdealer liquidity in the secondary market, including its technical recommendations to platform providers such as Eurex, to ensure liquidity improves in the weeks to come," said Mark Austen, managing director of ECBDA.
Dirk Burmeister, head of covered bond trading at UBS, added that the market has witnessed some spread tightening in certain names in the secondary market, and secondary liquidity is expected to further improve as the ECB announces more details of the buyback this month.
The ECBDA expects a return to some form of electronic trading of covered bonds in the coming weeks that, coupled with the ECB buyback program, can only be a good sign for the sustained recovery of this market.
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