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Banks sold a record amount of ultra-safe mortgage-backed debt in the first half of the year, rushing to lock in a cheap source of funding during a turbulent period for the sector with lenders facing growing political pressure to offer chunkier interest rates to depositors.
More than €175bn of so-called covered bonds were sold to investors in the six months to June, surpassing the previous high in 2011, according to data from S&P Global Ratings.
Covered bonds — a largely European phenomenon but increasingly popular with lenders in Australia and Canada — are a form of usually triple A rated debt not only backed by the bank that issues them, but also an underlying pool of assets, typically mortgages on the bank’s balance sheet. That extra layer of protection makes them a particularly inexpensive form of borrowing and an extremely safe, if low-yielding, asset for investors.
Advocates are fond of boasting that not a single covered bond — which lie at the opposite end of the risk spectrum to racier additional tier 1 (AT1) bonds — has defaulted since they were first dreamt up in the court of Prussia’s Frederick the Great more than 250 years ago.
Banks’ record covered bond issuance this year came during the banking sector’s most tumultuous period since the great financial crisis. Rapid deposit outflows brought about the collapse of three midsized US banks in March, weeks before the downfall of Credit Suisse, whose AT1 bonds were controversially wiped out by Swiss regulators during the lender’s emergency rescue.
“Covered bonds are a very dull product but because they’re pretty safe they’re seen as a beacon of stability, a funding tool for banks made for rainy days,” said Joost Beaumont, an analyst at ABN Amro. “We haven’t seen this amount issued by this stage ever before.”
The flurry of issuance has also been fuelled by the winding down of pandemic-era support from central banks for debt markets and the banking sector. Some banks rushed to issue during the tail-end of the European Central Bank’s quantitative easing programme, under which it has bought hundreds of billions of euros of covered bonds over the past decade, analysts say.
The central bank stopped buying covered bonds in primary markets in March, three months before it halted purchases in secondary markets, in effect removing a safety net for new issuance.
Banks are also keen to replace ultra-cheap central bank funding. The ECB’s exit from bond markets coincided with a flurry of repayments of funds distributed under its targeted longer-term refinancing operation (TLTRO), in which more than €2tn was loaned to lenders at negative interest rates during the pandemic. Eurozone banks had repaid half of that figure by mid-June, partly financing the payments via covered bonds.
UK banks are thinking ahead to the end of a Bank of England funding scheme, which was launched in 2020 to offer four-year funding at or very close to the BoE’s benchmark interest rate. The scheme was intended to help banks and building societies which were unable to reduce deposit rates much further amid fears it could limit their ability to lend.
One senior banker said they expected more covered bond issuance to replace funding as the scheme started to run down. “We are already seeing covered bond issuance booming,” they said. Another banker said that more covered bond issuance was because of “greater normalisation of interest rates” as the glut of retail deposits which flowed into UK banks during the pandemic started to run down and banks looked to other sources of wholesale funding.
Richard Barnes, a credit analyst at S&P said: “As retail deposits start to reduce and banks start to look at [BoE funding scheme] maturities, there may be more pick up in activity by banks in the wholesale markets in areas such as covered bond issuance. Banks will look at their funding early.”
The gradual draining of liquidity from the financial system caused by the reversal of central banks’ quantitative easing programmes is likely to raise banks’ funding costs at a time when many stand accused of profiting at savers’ expense by being slow to pass on interest rate rises to ordinary depositors.
In Europe, just 20 per cent of the increase in policy rates has been passed on by banks to deposit holders, less than in previous monetary tightening cycles, according to S&P.
UK banks have meanwhile had their net interest margins — the difference between the interest banks charge on their loans and the rate they pay on deposits — tick higher in recent months, inviting a barrage of criticism from regulators.
As UK banks come under pressure to raise savings rates, the battle for retail deposits will intensify and so banks may look to other sources of wholesale funds such as covered bonds.
Despite the bonds’ reputation for safety, the state of the property assets backing them has risen to the top of investors’ list of concerns in recent months as higher interest rates have begun to weigh on real estate valuations.
Trouble across the property sector “is on investors’ radar”, said Beaumont of ABN Amro. But the “dynamic” nature of covered bonds’ pools of assets, which can be constantly replenished as poor-performing properties lose value, means “you’d need to move to Armageddon-type scenarios for something to really go wrong”.
