Covered Bonds Update LCR-induced rally has run its course

Investment Research 14 October 2014 Covered Bonds Update LCR-induced rally has run its course Last Friday, the European Commission (EC) published details on the treatment of covered bonds in the upcoming regulation on the Liquidity Coverage Ratio (LCR), governing the composition of banks liquidity buffers. Bottom line: Outcome overall as expected, with a few surprises Overall, the outcome is largely as expected and is consistent with previously leaked drafts, entailing a favourable treatment of covered bonds compared with the original Basel proposal. While the latter restricted covered bonds to be eligible only as level 2A assets, implying a 40% portfolio cap and a 15% haircut, the EU implementation of the Basel rules opens up for several concessions. Most importantly, higher rated covered bonds are eligible for level 1B inclusion, while single-a rated covered bonds can be included in the level 2A category. This is consistent with previously leaked information and was thus to be expected. Surprisingly, however, the Delegated Act takes a step further, opening the way for lower rated covered bonds to be included in the level 2B category. The full implementation date has been moved forward one year earlier than envisaged under Basel III, to 1 January 2018. The outcome on the LCR is the latest in a series of regulatory initiatives treating covered bonds favourably (e.g. exemption from bail-in, preferential risk weighting under CRR). In our view, this is testament to the systemic importance of covered bonds as a funding tool in the EU and should continue to underpin overall investor demand for the product. Moreover, it makes economic sense to include certain covered bonds, whose excellent liquidity features were confirmed by the EBA s study released in December, in the top liquidity category. The broad inclusion of covered bonds in three LCR asset categories is also positive, as it reduces rating cliffs caused by the impact of potential covered bond ratings migration on the product s regulatory treatment. Key points LCR outcome largely as expected; highly-rated covered bonds eligible for level 1B inclusion, while single- A rated covered bonds may be included in the level 2A category. One surprise is the inclusion of certain lower rated covered bonds as level 2B assets In our view, the LCR-induced rally has run its course. We apply a simplified framework to analyse the relative value of covered bonds versus government bonds from a bank treasury perspective. Our calculations indicate that there is not much scope for LCR-induced demand to drive spreads tighter from their current levels. Nonetheless, in our view, other drivers for tighter covered bond spreads remain in place. That said, in our view the LCR-induced rally has mostly run its course. We apply a simplified framework to analyse the relative value of covered bonds versus government bonds from a bank treasury perspective. Our calculations indicate that there is not much scope for LCR-induced demand to drive spreads tighter from their current levels. This conclusion is also supported by EBA data, which show that most EU banks already meet LCR requirements. Nonetheless, other drivers for tighter covered bond spreads remain in place. In our view, the contraction in market volume caused by sizeable redemptions and little fresh supply is the key driver for tighter spreads. The ECB s CBPP3 programme is a further supportive factor for the covered bond market. Senior Analyst Sverre Holbek +45 4514 8882 holb@danskebank.dk Senior Analyst Søren Skov Hansen +45 4512 8430 srha@danskebank.dk Important disclosures and certifications are contained from page 2 of this report. www.danskeresearch.com

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Covered Bonds Update Market implications: LCR unlikely to drive spreads much tighter The LCR outcome is largely as expected by market participants, as the key points have already been leaked in previous months. In our view, the expected favourable treatment of certain higher rated covered bonds has also been a key factor behind the rise in bank investors take-up of core primary market deals (see Chart 1). For primary market deals from core jurisdictions, bank investors absorbed some 50% of supply on average in the third quarter of 2014 and they have also become the most significant investor group on an overall basis when looking at the aggregate supply of EUR benchmark covered bonds. Hence, understanding bank investor behaviour seems to be an important input when assessing the relative value of core covered bonds versus other asset classes. In order to gauge the economic impact of the covered bond haircuts implied by the LCR regulation and to examine whether there is still room for additional convergence of covered bonds versus government bonds, we apply a simplified framework for analysing covered bond investments from a bank treasury perspective. In doing so, we take into account the LCR haircuts, as well as the non-zero risk weighting of covered bonds under the standardised approach. The former requires a higher notional on the covered bond investment for a given LCR contribution (equivalent to 1/(1-haircut)), which we assume to be funded by senior debt. In our analysis, we look only at simple yield and ignore other considerations, such as differences in credit quality, ratings, liquidity, etc. Chart 1. Primary market investor distribution for Nordic, German and Austrian EUR benchmark deals 70% 60% 50% 40% 30% 20% 10% 0% 2012 2013 2014 Banks Real money Source: BondRadar, Danske Bank Markets In Chart 2, we show the break-even spreads required by bank investors to be indifferent between covered bonds and the underlying sovereigns for selected bond pairs in the four to five year segment. We apply three different scenarios for the required CET1 ratio, the cost of CET1 capital and the senior funding cost. Chart 2. LCR break-even spreads for selected covered-government bond pairs (core jurisdictions) 0,50% 0,40% 0,30% PBBGR (06/19) SHBASS (04/19) BNPPCB (02/19) INTNED (05/19) 0,50% 0,40% 0,30% 0,20% 0,20% 0,10% 0,10% 0,00% 0,00% DBR (07/19) SWED (05/19) FRTR (04/19) NETHER (07/19) Gov. yld CET1: 8% reqd, 10% cost. Snr: 0.5% CET1: 12% reqd, 10% cost. Snr: 1.0% CET1: 16% reqd, 10% cost. Snr: 1.5% Cov. yld Source: Bloomberg, Danske Bank Markets calculations Our analysis shows that covered bonds in several jurisdictions are already trading at tight levels versus the underlying sovereigns. In the base case, we set the required CET1 ratio equal to 12% and assume CET1 capital costs of 10% and a cost of senior funding of 1.0% (equivalent to the yield on iboxx EUR Bank Senior). In this scenario, only PBBGR offers value versus the underlying sovereign when LCR haircuts and the 10% risk-weight assumption are accounted for. Even when setting the required CET1 ratio to 8% and the senior funding cost to 0.5%, SHBASS and INTNED offer only marginal value, while BNPPCB is still trading too tight. Hence, based on our stylised calculations, we do not see much scope for LCR-induced demand to drive spreads tighter from their current levels. 2 14 October 2014 www.danskeresearch.com

In the analysis presented above, we have looked only at covered bonds expected to qualify as level 1B assets. While several of the stronger peripheral issuers would be expected to be included in the level 2A category, they generally trade tighter than the underlying sovereigns, making them less attractive from a yield perspective, especially when LCR haircuts and risk weights are taken into account. There could, however, be an incentive for bank investors to include some of the weaker, but higher-yielding names as level 2B assets. However, the eligibility criteria especially concerning the underlying assets is likely to significantly limit the scope of covered bonds that may be targeted. The results from the EBA s latest Basel III monitoring exercise (link) is another argument supporting our conclusion that the LCR-induced rally has mostly run its course. According to EBA, by end-2013, 71% of Group 1 banks (defined as internationally active banks with Tier 1 capital in excess of EUR3bn) were 100% LCR compliant, while only one bank was below the 60% threshold that is to be implemented by October 2015. While the ratio of compliance was slightly lower among Group 2 banks (not internationally active banks with Tier 1 capital in excess of EUR3bn), only 11% needed to improve their liquidity position to reach 60% LCR. Notably, these figures do not take the more generous LCR treatment of covered bonds in the EU into account. The details: EU treatment of covered bonds under the LCR According to the Delegated Act, covered bonds will be eligible for three asset categories, as described in the following. Note that all haircuts are minimum levels. Level 1(B): Certain covered bonds may be included in the level 1 asset category, though in contrast with other level 1 assets, they will be subject to a 7% haircut and a 70% portfolio cap (applying to the combined holdings of level 1B and 2A covered bonds). To be included in this category, covered bonds must satisfy the following conditions. UCITS or CRR compliance. Exposures to credit institutions must be compliant with CRR Article 129(1)(c). The investor and the issuer meet CRR Article 129(7) on transparency. The issue size must be EUR500m or larger (or domestic currency equivalent). Rating of at least AA-, or, where no rating has been assigned, a 10% risk weight under Article 129(5) of CRR. The cover pool meets a minimum OC requirement of 2% at all times. Level 2A: Qualifying covered bonds included in this category are subject to a haircut of 15% and a portfolio cap of 40% (while counting towards the overall cap of 70%). Besides the first three points mentioned above, level 2A covered bonds must meet the following: The issue size must be EUR250m or larger (or domestic currency equivalent). Rating of at least A-, or, where no rating has been assigned, a 20% risk weight under Article 129(5) of CRR. The cover pool meets a minimum OC requirement of 7% at all times. However, covered bonds that meet all criteria for level 1B except the minimum size requirement need only a minimum OC level of 2% to be included in the level 2A category. 3 14 October 2014 www.danskeresearch.com

Moreover, non-eea covered bonds are also included in this category, provided they are issued under a legal framework and are backed by public sector, residential or commercial assets, or ships. Such covered bonds must also satisfy the requirements on exposures to institutions and transparency. The minimum rating accepted is AA- and the OC level must exceed 7%. While there is no minimum size requirement, the minimum OC level is lowered to 2% if the issue size exceeds EUR500m. Level 2B: Another surprise element of the Delegated Act is the inclusion of covered bonds with no rating constraint in the level 2B category, subject to 30% haircut and a 15% portfolio cap. Such covered bonds must be UCITS or CRR compliant. Furthermore, the investing institution must satisfy the transparency requirements of CRR 129(7), with the issuer publishing the information at least quarterly (not semi-annually, as required by CRR). The issue size must be at least EUR250m (or the domestic currency equivalent), and the cover pool must meet an OC requirement of 10%, which must be publicly disclosed on a monthly basis. The cover pool is restricted to EEA public sector assets, residential mortgages or guaranteed home loans, qualifying for a risk weight of 35% or lower. The Delegated Act provides some clarification on the issue of OC, referring to the national law of a Member State or a third country for the definition of the asset coverage requirement. However, according to the Covered Bond Report (link), it seems that a minimum OC percentage as such is not required to be embedded in the legislation. Within the coming three months, the EC s Delegated Act will be presented to the European Parliament, which can reject but not amend the act. If the Delegated Act is approved, LCR will be implemented step by step, starting with 60% compliance by 1 October 2015, rising to 70% by 1 January 2016, 80% by 1 January 2017 and to full implementation by 1 January 2018. This is one year earlier than required by the Basel standard. Should the Delegated Act be rejected, the EC could make changes to the act and the implementation date could be pushed further into the future. 4 14 October 2014 www.danskeresearch.com

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