Goldilocks zone

While Australia’s major banks took advantage of record liquidity and competitive pricing in their home market in the first quarter of 2019, European bank issuance enjoyed an upswing of its own. European market sources say the positive environment has been supported by an economic backdrop that is neither as bad as it has been nor as good as it could be.

Matt Zaunmayr Staff Writer KANGANEWS

Europe experienced at least its fair share of the volatility that hit global markets in the latter months of 2018, exacerbated by the slow grind of Brexit and ongoing eurozone economic issues. This risk-off tone carried through into the initial weeks of 2019, leading to a particularly active January and February in the euro covered bond market as banks turned to the safest asset available to keep up with their funding run rates (see box).

The Brexit process only became more chaotic in the first quarter while eurozone economic data have in general been poor. Nonetheless, market sentiment has swung.

Vincent Robillard, head of group funding and collateral management at Societe Generale (SocGen) in Paris, tells KangaNews that conditions in euros and elsewhere were highly conducive at the end of Q1, with a significant spread retraction after the widening at the end of 2018 and start of 2019.

This market rebound was at least in part a technical-driven event. Speaking at the KangaNews DCM Summit 2019 in Sydney on 19 March, Andrew Santone, head of capital markets, Europe at National Australia Bank, said investors in the UK and Eurozone had been building up cash late in 2018 due to the Brexit process and market volatility. Eventually, the buy side simply needed to deploy funds in yielding assets.

Meanwhile, Javier Carballo, Hong Kong-based managing director, debt origination and advisory at Crédit Agricole, says issuers also held over issuance plans from the back end of 2018 and were therefore more than ready to execute in a more conducive pricing and liquidity environment.

Spreads across asset classes and markets have rallied, making conditions appealing for Australian corporate issuers among others. Robillard says there is now liquidity in all asset classes. He highlights the success of SocGen’s own €1.25 billion (US$1.4 billion), 10-year senior-nonpreferred deal as well as various from additional tier-one (AT1) to covered-bond format which have been well subscribed and tightly priced.

Peter Green, head of public senior funding and covered bonds at Lloyds Bank in London, says: “At the margin, there has been outperformance in AT1 given the coupons available. With central banks likely to be on hold or accommodative, the hunt for yield becomes more important for some investors.”

Santone says a five-year euro deal at the beginning of the year might have required a 20 basis points new-issue concession. By mid-March this had closed to low single digits. Investors have also found value in the 10- and 12-year buckets.

“The fall in yields is most prominently evidencing the central-bank paradigm change, which opens the door for further dovish policies. This suggests a less favourable supply-demand balance for investors which in turn supports spreads.”

Settled outlook

The positive market tone emerged despite the UK’s prospective withdrawal from the European Union seeming to move, one dramatic inch at a time, towards a still-unknown conclusion.

While the process dragged on markets in 2018, Neil Calder, London-based head of portfolio management, credit at European Bank for Reconstruction and Development, suggests markets have now effectively discounted the process and are getting on with putting money to work.

Indeed, British banks have been able to access capital markets in Europe and in the US despite the seemingly endless Brexit process, according to George Kalbin, FIG syndicate at Crédit Agricole in London.

Market sources say while European political issues – perhaps most notably the Italian budget – remain significant risk factors in 2019, they do not appear to be causing market disruption to the same extent they did last year.

This is perhaps even more surprising because economic data prints from continental Europe in the first quarter suggest a moderation in growth during 2019 is likely while inflation continues to be negligible. Robeco’s Credit Quarterly Outlook Q2 2019 notes: “Europe is much more dependent on global trade than the US. This helps to explain the disappointing economic data from Germany, [which] centred on weak export orders”.

What may be happening in Europe is something of what Carballo calls a “Goldilocks zone” for the credit market. The economic and political tone is not considered sufficiently dire to derail issuance but is poor enough to take any expectations of rate hikes well and truly off the table.

Aside from political issues, in 2018 spread direction was driven by the pace of interest-rate normalisation that the ECB and – even more so – the US Federal Reserve (Fed) appeared to be on. Weaker economic data have prompted a revised rates outlook, with a consequent change of view on credit spreads.

For instance, David Hunt, Newark-based president and chief executive officer at PGIM, says the rising rate environment of 2018 was an abnormality and he expects rates to remain low for the foreseeable future.

Patrick Seifert, managing director and head of primary markets at Landesbank Baden-Württemberg (LBBW) in Stuttgart, agrees that the Fed pause and ECB reversal have changed credit sentiment. “The fall in yields is most prominently evidencing the central-bank paradigm change, which opens the door for further dovish policies,” he comments. “This suggests a less favourable supply-demand balance for investors which in turn supports spreads.”

Victor Verberk, co-head, credit and lead portfolio manager, investment-grade credits at Robeco in Rotterdam, adds: “Outside equities, investors in Europe have few options in the search for yield other than to buy credit.”

The implication is that the rally is less to do with genuinely positive sentiment and more the product of technical factors. How long the rally can hold amid deteriorating macroeconomic and political conditions is a subject of debate.

“At the margin, there has been outperformance in AT1 given the coupons available. With central banks likely to be on hold or accommodative, the hunt for yield becomes more important for some investors.”

Under the covereds

Covered bonds were clearly a favoured asset class for banks’ euro issuance at the start of 2019. While the first months of any year tend to be the most active for covered-bond issuance, market sources say the end of the European Central Bank (ECB)’s buying programme increased the product’s value for investors.

Karlo Fuchs, executive director, covered-bond ratings at Scope Ratings in Frankfurt, tells KangaNews there was around €60 billion (US$67.7 billion) of benchmark covered-bond issuance in Q1 2019, a 25 per cent increase in volume from the first quarter of 2018 and the highest amount since 2012. This issuance surge was in part the product of a general risk-off tone. But there are also signs of covered-bond-specific demand enjoying a resurgence.

Fuchs says demand for the product has been suppressed in recent years due to negative interest rates. With the ECB’s asset-purchase schemes now winding down and spreads widening as a result, Fuchs tells KangaNews a larger group of investors have begun to find covered bonds appealing as new-issue spreads have finally moved back into positive territory.


Central banks were accounting for around a third of covered-bond deals but they are now typically in the mid-teens. Banks were also at around a third but are now accounting for around 50 per cent of transactions.

TLTRO impact

The extent of the underlying malaise in Europe is emphasised by the fact the ECB has still not been able completely to turn off the QE taps. In fact, it will once again seek to ease pressure on bank funding via the third iteration of its targeted longer-term refinancing operations (TLTRO), to commence in September 2019.

Earlier TLTRO packages, announced in 2014 and 2016, were designed to incentivise bank lending to the real economy by providing participating banks with funding at a cost linked to the amount of lending to nonfinancial corporates and households they facilitated.

Frank Mirenzi, vice president and senior analyst, financial institutions at Moody’s Investors Service in Sydney, says with around €720 billion of previous TLTRO funding coming up for refinancing, the new package should smooth the process for banks predominantly in Spain and Italy.

The news is not as good for investors which have been starved of relative value. Calder says the portfolios he manages have never had such a low exposure to credit from core European countries. “When the announcement was made late last year that there would be no new net buying by the ECB, we began to see some opportunity in euros – they began to represent reasonable value swapped into US dollars. As soon as the ECB announced further QE measures, spreads began to tighten and those relative-value gains quickly dissipated,” he explains.

However, Kalbin argues that the consequences for the wider financial-institution market are likely to be limited by the fact that there is no new liquidity planned with TLTRO III, only debt being rolled over – as the new liquidity will likely carry slightly less advantageous terms.

Meanwhile, Andreas Wein, head of funding and debt investor relations at LBBW in Stuttgart, is convinced TLTRO III will further reinforce name differentiation between stronger credits and institutions which are in structural need of central-bank funding. This distinction means investors have reason to be relatively positive on FIs in core European countries, according to Verberk. He says the fundamentals of most northern European banks are strong.

The ECB has ruled out a rate hike in 2019, and many expect it will be on hold well beyond the end of this year. Whether this means a flat track for the market going forward is not clear.

Ed Farley, London-based head of European and global corporate bonds at PGIM, says: “While it appears that developed-market central banks may be coming to terms with the ‘lower for longer’ rate theme, some European insurance companies have moved into longer maturities to hit their yield targets. Volatility could still emerge, however, as demand for yield could be offset by fears of stalling economic growth.”

Markets appear to be brushing off issues like Brexit, European parliament elections in May and Italian sovereign risk. But these are all unresolved risks that could cause negative impacts in European markets if they boil over. Verberk believes the market is experiencing only a temporary recovery.

If it returns in force, volatility may be at least partially offset by stable funding requirements from most financial institutions, according to Robillard. He questions analysis that issuance in senior format from holding companies in Europe will rise, saying it is more likely to be flat and thus provide support for spreads.

In this context banks will have been well served to take advantage of conditions in Q1, and many appear to have taken this lesson to heart. As Carballo points out, issuance in euros for the first quarter of 2019 was around half the volume issued in total in 2017 or 2018. He tells KangaNews: “The entire capital structure is currently well bid and investors are happy to go out on the maturity spectrum, too. Comfort on rates is driving this, and thus the technical rally should be maintained so as long as there is rate stability.”

According to Kalbin, the ECB appears ready to tackle economic or political instability that may arise, with stimulus. He adds that the main risk he sees is to investors as more liquidity continues to come back into the system. “The five-year swap is currently trading close to flat,” he tells KangaNews. “Last time it was negative was in 2016 and at that point investors were compensated in the overall swap level. Now, with all the liquidity being pumped into the market, underlying yields are decreasing but investors are not being compensated in spread because those are decreasing as well.”