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Bail-in rules, easy ECB money curb covered bond issuance at Europe's banks

A slump in covered bond issuance is likely to prevail as long as European banks continue to feel the effects of new bail-in-able debt rules and ultracheap European Central Bank funding.

The market in euro-denominated benchmark covered bonds — securities that are backed by mortgages or other loans — has been shrinking over the past few years, and with the funding priorities of many eurozone-based banks set to change as they comply with new capital regulations designed to prevent future taxpayer-funded bailouts, their issuance is likely to remain depressed, analysts say.

The final round of the ECB's latest targeted longer-term refinancing operations program, TLTRO II, has also helped keep a lid on the covered bond market, and further easy money programs could curb issuance over the coming years.

Cheap money

The ECB extends four-year TLTRO loans to commercial banks at very favorable rates with the aim of stimulating lending to the real economy. In the final TLTRO II allotment in the first quarter, 474 European banks took up €233.5 billion of such funding; far more than in previous quarters. Taking these ECB loans lessens the advantage of issuing covered bonds, which are generally perceived as one of the cheapest forms of bank funding.

Such a high level of demand for TLTRO was a surprise, according to NORD/LB senior covered bond analyst Mathias Melms. In an interview, he said he has now revised down his expectations for covered bond issuance in 2017 to €110 billion, from about €122 billion.

"We think that issuance volume in the second half of the year will be definitely lower than in the first," Melms said. "Our base scenario is that we will see issuance of another €40 billion up to €50 billion. But definitely not another €60 billion for the remaining part of [2017]."

In the first five months of 2017, issuance of euro-denominated benchmark covered bonds totaled €65 billion, significantly lower than the €84 billion issued in the same period of 2016, ABN AMRO fixed income strategist Joost Beaumont said in a report.

The bail-in effect

Besides the impact of TLTRO and an expected tapering of the ECB's quantitative easing program after the summer break, the covered bond market will also be affected by the need for major eurozone banks to issue regulatory compliant bail-in-able debt, according to Melms.

Global systemically important banks, or GSIBs, which include France's BNP Paribas SA, Société Générale SA and Crédit Agricole SA and Germany's Deutsche Bank AG, are required to hold a certain amount of debt that can be bailed in if they run into trouble. The so-called total loss-absorbing capacity rules — or TLAC — are designed to prevent a repeat of the financial crisis-era government bailouts. Banks must also meet Europe-specific minimum requirement for own funds and eligible liabilities, or MREL, rules, due to be phased in in two stages, from January 2019 and January 2022.

"MREL and TLAC will influence the issuance volume of covered bonds negatively [because] banks [can] only issue one as they need the money," said Melms. Many issuers, particularly in France and Spain, would like to issue covered bonds but cannot because they have to issue MREL or TLAC debt, he said.

Ruben van Leeuwen, a senior asset-backed securities and covered bond analyst at Rabobank, said in an interview that there is much more of a focus on TLAC- and MREL-eligible instruments such as so-called senior nonpreferred bonds in France.

With a lack of clarity around the bail-in-able debt, different countries have taken different approaches, with France creating a new category of sub-senior, or senior nonpreferred.

Banks will be issuing this debt well ahead of the new rules coming into effect, according to rating agency DBRS.

"France has already started ... Everybody tries to meet the requirements as soon as possible," said Gordon Kerr, DBRS senior vice president and head of EU research in global structured finance, in an interview. "Absolutely the focus this year will be on the lower end of the capital stack."

Market outlook

In its outlook for the euro benchmark covered bond market in 2017, DBRS said gross supply from established European jurisdictions is likely to remain subdued as banks are expected "to be busy building up unsecured and subordinate issuance" to meet MREL requirements.

ABN AMRO's Beaumont projected gross supply of covered bonds in the range of €110 billion to €115 billion for 2017, and a negative net supply for the full year, with more redemptions than new issues. In a forecast on Dec. 7, 2016, he said net supply of euro benchmark covered bonds has been negative for three of the past four years, surpassing redemption volumes only in 2015. In total, the covered bond market has shrunk by around €100 billion over the last few years, according to the bank.

But in spite of current muted issuance, covered bonds remain a good source of funding and, once TLTRO has ended and the TLAC/MREL effect on the market wears off, the market should recover, according to the analysts.

"If you just look the fundamentals supply-wise, I think that once banks are sufficiently capitalized and have met all their TLAC/MREL requirements they will go for the cheapest funding source available — and that is covered bonds," Van Leeuwen said.

Melms expects low maturities to depress new euro-denominated covered bond issuance to €95 billion in 2018, but then sees issuance improving to €110 billion in 2019 and €120 billion in 2020. In 2021, when the final TLTRO II loans mature, it could potentially surge to €160 billion.

"2021 is a long way to go but if we don't have a [new] TLTRO program banks will need to replace the TLTRO II money with something and the natural choice would be covered bonds," he said.