Senior attractions and redemptions to play into 2013 supply dynamics

Nov 15th, 2012

Senior unsecured will be the cornerstone of bank funding in 2013, forecasts Vincent Hoarau, Head of FIs, Covered Bond & ABS Syndicate at Crédit Agricole CIB, with covered bond supply being partially led by the periphery and Nordic covered bonds being in a strong position.

Vincent Hoarau

From what investors are telling us, it appears that covered bonds will continue to play a prominent role in investment portfolios next year even though most of them are already deeply concerned about the prevailing lack of supply and issuance prospects when they look ahead. Indeed the bulk of offerings of financial institution paper next year will very likely come from the senior unsecured and subordinated debt markets.

It has been clear for some time now that the level of new euro benchmark covered bond issuance in 2013 will not increase much compared with 2012. Total supply of euro benchmark covered bonds in full-year 2011 amounted to Eu192bn. Year-to-date euro benchmark covered bond issuance amounts to around Eu92bn. We believe that in 2013 it will turn out to be similar to this year’s level, and we therefore predict a defensive Eu90bn of supply in euro benchmark format (Eu500m+ deals).

Focus on senior and a better funding mix

In 2013 — as with the second half of 2012 — banks will not go systematically into cheap covered bond funding in the way they did during the darkest phase of the crisis. They will prefer senior unsecured deals and subordinated trades.

There are a few key reasons for this: consolidation moves combined with ongoing deleveraging resulting in a falling stock of assets available as collateral; ongoing cheap central bank repo solutions; rating agency as well as regulatory requirements making covered bond funding much more expensive; but also the evolution of housing markets, as in France, where the production of housing loans is declining.

More importantly, the encumbrance topic and the recent spread compression observed between senior and covered bond paper will encourage issuers from core jurisdictions — whence the bulk of covered bond supply arrived in 2012 — to tap the senior unsecured market at relatively cheap all-in funding levels. Should the normalisation go on, weaker names and/or peripheral names will be forced to tap the senior market and to deliver “showcase trades” at wide absolute spread levels to demonstrate that they have access to wholesale senior unsecured bank funding.

Elsewhere, covered bond benchmark issuance in euro denominated format should not increase also because (a) access to covered bond issuance in other currencies will continue to increase — for low as well as higher beta names — and (b) because issuance in private placement format will increase significantly.

Negative net covered bond supply in 2013

Looking down the road of redemptions in euro denominated format, benchmark covered bond redemptions will jump to Eu147.5bn in 2013 after dropping from Eu122bn to Eu98.5bn from 2011 to 2012. Given the forecast negative net supply in covered bonds (minus Eu57.5bn), low beta senior unsecured paper could be the asset class of choice for reinvestment, very likely at the intermediate to long end of the curve.

Out of the total covered bond redemptions for 2013, approximately Eu39bn are from Spain (+86%), Eu37.5bn from Germany (+10%), Eu28.5bn from France (+76%), and Eu11bn from the UK (+266%). Combined benchmark redemptions for Denmark, Finland, Norway, and Sweden amount to only Eu9bn for 2013. It is nevertheless the biggest year of redemptions so far for the Nordic covered bond benchmark segment. Nordic euro benchmark redemptions amounted to Eu4.1bn in 2012. They will reach Eu12.35bn in 2014.

So far this year supply in benchmark covered bonds has mainly been driven by three areas. France, Nordic countries (mainly Norway) and Germany contributed slightly more than 50% of overall primary flows. In senior unsecured, out of Eu124bn of euro benchmark supply year-to-date, Eu29bn came from France, Eu25bn from the Nordics, and Eu22.5bn from the Benelux. Redemptions of senior unsecured benchmarks amount to Eu226bn in 2013.

Renaissance of the periphery driven by change in market psychology

Looking ahead, we expect spread compression in covered bonds and convergence across regions to continue in 2013. Given the amount of cédulas due in 2013 and to be rolled over, we expect issuance in cédulas format to increase significantly in 2013, with probably fewer Spanish issuers struggling with market access. The same is true of Italian second tier issuers. This will be driven partially by the psychology of the market and investor sentiment towards the periphery, which has changed dramatically in recent weeks.

Staying with Spain, even though issuers are at very low OC levels, they will certainly look to exchange some of their retained covered bond deals with capital markets transactions truly distributed with end investors. The same is true for Portugal issuers and the recent senior unsecured deal for BES is an encouraging signal.

It goes without saying that this assumption is particularly dependent on the broader market backdrop and the stabilisation of peripheral sovereign debt markets. We believe that conditions will slowly normalise for peripheral issuers even though volatility and the “stop-go” mode in primary will remain for weaker names. Whatever the final outcome for cédulas, we believe the Spanish segment will lead covered bond supply in 2013 together with other peripheral segments and France — even if issuance there will decline next year compared to this. Basically, we expect decreasing covered bond issuance volumes out of France, the Netherlands, the UK and Norway to be compensated by increasing volumes out of Spain, Italy, Belgium, Ireland, Sweden, and Portugal, the rest of the space remaining pretty stable.

Covered squeeze to go on and support absorption of senior unsecured paper

With the covered bond demand/supply dynamic strongly unbalanced in core markets, we expect spreads there to remain very resilient and pretty immune to any major spread widening, while the level of volatility in spreads and sentiment for senior debt should remain high, particularly in southern European credits.

Elsewhere, in early 2013 euro-zone issuers will also try to reimburse the two LTRO tranches as far as possible. This won’t trigger further massive needs for senior unsecured funding but will decrease the level of excess cash in the global credit markets. Having said that, the Eu34.5bn of benchmark covered bonds due in January 2013 alone should provide an outstanding support to the senior unsecured debt market.

On the one hand, we don’t expect much covered bond supply in January 2013 compared with January 2012 (no less than Eu33.5bn was issued in the first month of the year!). On the other hand, we do expect a shift of cash from the secured to the unsecured segment driven by the increasing amount of investors going down the credit curve in search of yield and spread and by issuers eager to achieve a better funding mix by favouring senior unsecured funding.

Strong technical supports for Nordic issuance

Looking at Nordic issuance for next year, we expect the bulk of euro covered bond supply to come from Finland, while current discussions on asset encumbrance in Norway will lead to a significant drop in covered bond issuance volumes and to a shift into senior unsecured funding.

DNB will likely be affected the most by this shift and could be rare in the public covered bond market, favouring senior unsecured benchmark funding in order to achieve a better funding mix. The Norwegian national champion contributed to approximately 30% of covered bond benchmark supply out of the four Nordic countries year-to-date. A relative absence of DNB combined with the amount of redemptions in Nordic covered bonds will accelerate the squeeze in the secondary market and support senior unsecured funding and spreads out of those regions.

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