Few covered bond traders have any inventory on their books and they are increasingly putting their offers to clients at aggressively defensive levels. Despite that clients continue to lift offers. And with dealers unable to source bonds from their existing inventory, many are now turning to the repo market.
“The repo market is trading incredibly tight, I’d be lucky to borrow bonds at 0% for anything under three years. Most of the market is trading at 0.5% to 1% through GC [General Collateral] and in extreme cases we’ve seen bonds like the CM-CIC 23s trading 6% through GC,” one dealer commented.
He went on to point out that repo contracts often contain break clauses enabling the lender to significantly increase the cost of collateral to the repo borrower. As a result, the cost of funding short positions is becoming increasingly onerous and this could well increase the risk of failed repo trades.
With another large dose of LTRO liquidity due at the end of February and many covered bond issuers staying away from the publicly syndicated market, the current situation can only get worse.
“I can see a situation where in a few months time we get forced buyers and forced delivery squeezes in the repo. If this happens dealers will simply stop offering bonds and the market will essentially become like a private placement market,” said the dealer.
In his opinion the ECB should more freely repo the bonds it already owns, as this would help improve underlying repo liquidity.
Though the ECB cannot lend out bonds that have been pledged to it by noteholders, it can repo bonds that it has bought through the first and second covered bond purchase programme. Though it has officially said that it would repo these bonds – it has not in practice actually done this.
According to a repo trader based in Frankfurt, the ECB lent out bonds in the first purchase programme through Clearstream’s automatic securities lending system on an overnight basis. But this is aimed at smoothing settlement – which is not the same as pledging bonds for full repo use.
Repo traders report that bonds can become scarce in the repo market for many reasons though principally because they have already been pledged by the holder to the central bank.
In such circumstances the holder would be better off taking the retained bonds out of repo with the central bank and putting them to use more lucratively thorough the bilateral repo market where returns can be as much as five or six times higher.
But they have so far failed to do this, probably because they don’t see regularly how the repo market trades.
Any number of bonds can be affected and they often don’t have anything to do with the credit quality of the borrower. Thus certain Eurohypo, DexMA and UniCredit covered bonds all trade ‘special’ in the repo, meaning at levels well through GC.
Repo traders reported that the impact of LTRO liquidity had also greatly affected the cost of short dated covered bonds in the repo market.
But in addition to that, German lenders have been forced to close out repos and recall collateral due to the imposition of the bank levy tax. The collateral is considered a balance sheet liability, which is therefore subject to the levy – unless it is pledged through a central counterparty such as Eurex or the London Clearing House.
One year Santander trades through bills.
The most conspicuous spread tightening has been at the short end with money market funds still actively looking for offers. One year cédulas issued by Santander now trades through one year Spanish treasury bills.
French two year bonds, which had traded around mid swaps 100bp at the start of the year for names like Crédit Agricole, have recently traded at half that spread level.
UK names in euros have also seen significant tightening, and with these issuers unable to access the ECB’s LTRO liquidity directly, issuance in this part of the curve could be one way of indirectly benefiting.
RBS September 2014s are indicated on a bid offer of mid swaps 85/75bp and Lloyds March 2015s are indicated at 130/120bp. But traders say they would feel very uncomfortable putting offers as wide as that.
New issue premium evaporates
“I can’t tell you where the next level trades at – but what I would say is that if an issuer chose to bring a deal in this part of the curve I very much doubt it would have to pay a new issue premium,” a dealer said.
The long end of the UK market is also well sought after, with euro denominated outstanding benchmarks in names like RBS and Lloyds tightening from around 175bp to 140/135bp.
While the short end is clearly buoyed by the froth of liquidity provided by the ECB, the long end has also performed well with German insurers still hankering for the 4% yield.
10-year French covered bonds have tightened around 25bp this year and even since Wednesday offers for most French long end deals have come in by another 5bp.
As a result, the spread levels now at the long end are pretty close to where they were at the end of last year. With little to no new issue premium likely to be needed and the Greek and Portuguese sovereign backdrop not certain, issuer’s may well be looking to take advantage of a the funding window that still remains open.
UK and French borrowers are prime candidates, though syndicate bankers believe they are more likely to go for five year deals, rather than the long end which has been well supplied.
Though issuers from Norway have been active, the remainder of the Scandinavian market looks set to remain fairly quiet as funding in the domestic currency and placing bonds with local investors remains by far the cheaper option. This is particularly the case with Swedish issuers due to the expensive basis swap.
German, Austrian, Italian and Spanish issuers are more focused on the LTRO, but issuance is not completely ruled out for some who may want to demonstrate an ability to bring deals, should they become economically viable.
Peripheral issuance hopes rise
Though the Spanish and especially Italian banks have taken considerable funding liquidity from the ECB, bankers have not ruled out the possibility that they might come to the market. Bankers say Italian borrowers might be tempted if they could fund inside 300bp. But the bonds would also need to offer a pick up to BTPs, which is currently not the case.
For example, five year UniCredit was lifted in the street yesterday at asset swaps plus 270bp and the market is now indicated at 280/250bp. But the August 2016 BTPs are trading at around 305bp mid. This suggests that a new primary Italian deal would still need to come with a spread over 300bp.
But with 10-year BTP yields continuing to fall, it may only be a matter of time before economically viable term funding can be locked in. BTP yields in the 10 year are 26bp down from their highs this morning, having fallen from 6.11% to 5.85%.
Spanish 10-year yields have likewise put in a strong performance and are down from 5.23% to 4.99% on Friday morning. A close below 4.80% would take the yield to levels not seen for a year, giving a strong signal that the government bond market is on a sustainable performance path.
The strong performance of peripheral government bond markets this morning follows high expectations that the Greek PSI deal will be agreed over this weekend.
"We are very close to a deal, if not today then over the weekend and preferably in January, not February. We are very close," Olli Rehn, European Economic and Monetary Affairs Commissioner, was reported to have said at the World Economic Forum in Davos.
Though the ECB is not expected to take a haircut, it is also unlikely to want to profit from the Greek bonds it bought via the Securities Market Programme at well below par. This suggests it will accept a compromise, as long as there is no book loss.