European Covered Bonds Shift Close to Sovereigns as Traders See Danger
As the covered bond legislation in the United States sits in committee awaiting an eventual vote in the House of Representatives, traders in Europe – where the product is traditionally based – report that prices are being pushed to "dangerous" levels. HR 4884, sponsored by Rep. Scott Garrett (R-NJ), would establish a legislative framework for covered bonds in the US. Supporters say its passage is vital to establish a healthy covered bond-trading network that is US-dollar based. Opponents argue that the bonds are too pricey, as dual recourse is required to keep investors shielded from losses. Such a platform, however, could provide origination-funding alternatives to the GSEs and federal home loan banks. The legislation is currently in referral to the Committee on Financial Services. Meanwhile in Europe, covered bonds are currently trading close to perspective sovereigns, especially in Germany (the largest market with Pfandbrief), Italy, Portugal and Spain. Traders at Société Générale say that a shortage of supply is pushing Pfandebrief higher. "In the past week peripheral sovereign bonds corrected, while covered bonds did not correct much," said Soc Gen trading coordinator José Sarafana. "Peripheral covered bonds are trading close to their respective sovereigns." (see chart below) "Such a constellation has produced underperformance in the past," he added. "We see spread differentials between the two asset classes of the same country of below 20bps as dangerous." Tim Skeet, the head of the covered bonds at Bank of America Merrill Lynch, is less concerned on the impact of recent activity on the nascent domestic covered bond market. "It is still early days for the US dollar covered bonds and we will need more time and volume before we can usefully talk about trading," he said, "that aside, the US covered bond market is likely to develop further once the vacation period has passed." Nevertheless, Skeet said that the Pfandbrief market is in parts buoyed by domestic German demand for a product they know and trust, pushing prices higher than a more skeptical international audience might have anticipated. Inevitably German investors place more faith in their own government and financial instruments than even those of neighbors, he added. Write to Jacob Gaffney.