Covered Bond Outlook 2018 – Supply returns, spreads stay at home

by: Joost Beaumont

The covered bond market shrank again in 2017

Gross supply of euro benchmark covered bonds slowed further in 2017, with issuance amounting to EUR 108bn (2016: EUR 122bn). This was also less than redemptions, implying that the market continued to shrink for another year. Meanwhile, the low interest rate environment pushed issuers further up the curve. 

Gross supply to stay stable in 2018 despite drop in redemptions

There are reasons to be cheerful moving into 2018. We have pencilled in EUR 105-110bn of euro benchmark covered bond issuance in 2018, the same amount as in 2017. This would mark a return to positive net supply due to the relatively low amount of redemptions. Indeed, we expect bank funding needs to rise on the back of booming housing markets. Furthermore, covered bond issuance will be supported by an increase in the number of covered bond issuers as well as the use of covered bonds as a tool to reduce overall bank funding costs.

No tapering of covered bonds

We do not expect the Eurosystem to change its covered bond purchases next year, as the reduction in total asset purchases will be mainly in the PSPP. Overall, we estimate that gross monthly purchases will on average amount to EUR 5bn, concentrated in the first half of 2018.

 Spreads unlikely to widen

We do not expect covered bond spreads to widen significantly next year. In fact, a number of factors should keep spreads compressed; scarcity, CBPP3, the fact that covered bond spreads are still much wider than government bonds, and the enhanced protection of covered bonds.

Remain overweight non-CBPP3 paper, periphery looks expensive

We stick to our view to remain overweight non-CBPP3 covered bonds, given that they offer a pickup as well as eventual ‘taper protection’. Meanwhile, peripheral covered bonds look expensive.

 We favour covered bonds over government bonds, shorten duration

Furthermore, we favour core covered bonds over core government bonds, as we expect the Eurosystem to reduce purchases of the latter. Finally, spread investors can currently shorten duration without a large give-up.

DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead. This report is marketing communication and not investment research and is intended for professional and eligible clients only.

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