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6 | ifr special report | October 2010 SSA/COVERED BONDS


ifre.com


ECB bond purchases and peripheral spreads bp


500


Average peripheral bond spread (Lhs) ECB bond purchases settled (Rhs)


375


€bn 20


15


250


10


Although Greece was effectively removed as the source of the instability in peripheral markets, the spotlight soon shifted to other countries which might also be in danger of suffering a similar fate. The spreads of Spain, Ireland and Portugal in particular soon started to rise. The ECB eventually responded by intervening to purchase the debt of Ireland, Portugal and Greece, although the latter had already been downgraded to junk status.


125 5 0


Apr 10


Source: Thomson Reuters


The execution of the programme and the initial inability to borrow through the repo market from the ECB turned the market from being offered only to largely bid only. As financial fears eased, the ECB investors’ perception that spreads on covered bonds would continue to widen, and primary markets consequently grew in confidence.


Refocus


Following the adoption of the common currency and the European convergence trade of the 1990s, peripheral spreads had traded in a narrow range. The general view held that there was very little difference in the credit of the eurozone members. Italy and Greece were perceived as the weakest members, although the spread between 10-year BTPs and Bunds rarely exceeded 30bp. After the financial crisis the spread increased and traded between plus 60bp and plus 80bp for most of 2009, before rising to plus 145bp in March, 2010 and peaking at plus 175bp in early June. The driver of the peripheral meltdown that occurred soon after the New Year cele- brations was a loss of confidence in Greece. This problem was exacerbated by an apparently successful five-year bond sale which widened by 40bp the day after it was priced. At the time the spread between 10-year Greece and Germany exceeded 400bp, with Greek bonds yielding more than twice as much as Bunds for the first time since early 2009. Two rating agencies, Fitch and Standard & Poor’s, had downgraded the sovereign


the previous month to BBB+, while Moody’s moved to A2 at the same time from A1 previously. Significantly, Moody’s remained the most important rating, as Greek paper remained eligible as ECB collateral if rated above Baa1 by Moody’s. In other words, Moody’s have would have had to downgrade the sovereign by two notches for Greek paper to lose its repo eligibility.


Subsequently, the debate shifted to whether the parlous state of Greek finances, after a 2.6% contraction in GDP in 2009, would receive support from the stronger European member states. Following a 10-year trade which initially maintained its launch spread, a seven-year issue in April proved to be Greece’s last public debt sale before the government was forced to request aid from a joint IMF/EU delegation that visited Athens later that month.


The spread on the new seven-year deal also came under pressure immediately after pricing despite 43% being sold to domestic investors (compared to 23% of the 10-year deal). In both cases the majority of the bonds placed with domestic financial insti- tutions were used as repo eligible collateral. The ECB was forced to ease its criteria in July to ensure financial institutions could secure financing at favourable rates, thereby assisting the process of financial and economic recovery. Although Moody’s now rates Greece at Ba1, the ECB still accepts Greek government debt as eligible collateral with the additional 5% haircut for government bonds rated below A minus.


May Jun Jul Aug 0


“Because the size of the sovereign debt market is much larger than the covered bond market, making the ECB’s objective more difficult to achieve, it was important to address the Greek situation (through market intervention) as this was the focal point of the recent sovereign spread divergence,”said Nathaniel Timbrell-Whittle co-head of SSA DCM at BNP Paribas.


A nominal amount of €16.5bn was acquired in the first week the ECB intervened in May. In the weeks that followed the purchases fell initially to €10bn and were €4bn per week by early July, averaging around €150m per week in the eight weeks to early September. The rapid decline in the amount of assets being purchased, while not irreversible, is largely seen to be directly correlated to the subsequent widening of peripheral spreads with Spain, Ireland, Portugal and, to a lesser extent, Italy all remaining vulnerable.


The weakness in peripheral markets continues to impact covered bond supply: “The fact that covered bond issuance levels have been under pressure in many jurisdic- tions was largely a function of the dislocation of the spreads of the underlying sovereigns, rather than being related to a perceived failure of the ECB’s covered bond purchase operation,” said Barcap’s Engelhard.


“The operation of the peripheral programme has, unlike with covered bonds, been applied on a much more variable basis and consequently the results are- at this stage- more mixed,” added Timbrell-Whittle at BNP Paribas.“In part this is because the purchase programme is only part of the ECB strategy to address the spread divergence that has occurred with the creation of EFSF effectively a means of insuring member states’ access to funding.”


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