In an era of ever-evolving financial dynamics, banks have embarked on a race to secure funding at unprecedented levels through the issuance of remarkably secure mortgage-backed debt. This surge in activity comes at a time of turbulence within the sector, as political pressures mount for lenders to offer more enticing interest rates to depositors. Data from S&P Global Ratings reveals that over €175 billion of covered bonds, renowned for their impeccable safety, were sold to investors in the first half of this year, surpassing the previous high achieved in 2011. These covered bonds, predominantly a European phenomenon but increasingly embraced by lenders in Australia and Canada, represent a form of debt that not only derives its security from the issuing bank but also from an underlying pool of assets, typically mortgages on the bank’s balance sheet. This additional layer of protection not only makes them an exceptionally cost-effective borrowing option but also an extraordinarily safe asset, albeit with relatively low yields, for investors.
Unveiling the Significance of Covered Bonds:
Champions of covered bonds boast that not a single one has defaulted since their conception over 250 years ago in the court of Prussia’s Frederick the Great. These bonds reside at the opposite end of the risk spectrum when compared to more adventurous additional tier 1 (AT1) bonds. Against the backdrop of the most tumultuous period for the banking sector since the great financial crisis, this year’s record-breaking issuance of covered bonds has become all the more remarkable.
The surge in covered bond sales has been driven by several factors. Firstly, the winding down of pandemic-era support from central banks for debt markets and the banking sector has prompted banks to expedite their issuance plans. Some banks hastened their offerings toward the end of the European Central Bank’s quantitative easing program, during which the central bank purchased hundreds of billions of euros worth of covered bonds over the past decade.
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Moreover, the cessation of the central bank’s purchases of covered bonds in primary markets in March, followed by the halt of purchases in secondary markets, effectively removed a safety net for new issuance. This development, coupled with banks’ desire to replace ultra-cheap central bank funding, led to a flurry of repayments of funds distributed under the European Central Bank’s targeted longer-term refinancing operation (TLTRO). The repayment amounts were partly financed through covered bond issuances.
Anticipating the conclusion of the Bank of England’s funding scheme, launched in 2020 to provide banks and building societies with four-year funding at or near the benchmark interest rate, UK banks have also entered the arena of covered bond issuance. As the scheme nears its end, banks are expected to increase their covered bond activities to replace the diminishing funding options. This is particularly relevant as the excess retail deposits that flowed into UK banks during the pandemic gradually decrease, necessitating alternative sources of wholesale funding.
Implications of the Financial Landscape:
The gradual reduction of liquidity resulting from the reversal of central banks’ quantitative easing programs is likely to raise banks’ funding costs, exacerbating accusations that many institutions have been slow to pass on interest rate increases to ordinary depositors. In Europe, only 20% of the policy rate increases have been transmitted to deposit holders, which is lower than in previous monetary tightening cycles, according to S&P. Concurrently, UK banks have experienced a slight uptick in their net interest margins, attracting criticism from regulators.
As pressure mounts on UK banks to raise savings rates, the competition for retail deposits is expected to intensify, prompting banks to explore other avenues for wholesale funding, including covered bonds. Although concerns about the underlying property assets supporting these bonds have emerged as higher interest rates impact real estate valuations, the dynamic nature of the pools of assets backing covered bonds suggests that catastrophic scenarios would be required for significant disruptions to occur.
The record-breaking sales of covered bonds by banks amid the current financial climate underscore the significance of seeking cost-effective and secure funding sources. As the sector faces volatility and dwindling central bank support, financial institutions have capitalized on the opportunity to fortify their positions by leveraging the unique qualities of covered bonds. Despite the intricacies and potential challenges that lie ahead, the market’s response to these offerings reaffirms the continued relevance and appeal of covered bonds as a reliable funding tool for banks. As the financial landscape evolves, the impact of these debt instruments on the industry’s stability and resilience will undoubtedly shape the strategies and priorities of financial institutions for years to come.
