Liquidity buffers play second fiddle to reg treatment
The size of a covered bond liquidity buffer that protects investors against the risk of payment disruption should be an important risk consideration, but there is no incentive to play safe as regulatory and central bank treatment of the asset class play more pivotal roles in valuations.
The Swedish and German governments are in the process of transposing the EU’s Covered Bond Directive. Both countries are contemplating soft bullet regimes that would allow a deal to be extended by a year if an issuer defaults. They are also working on stipulations over liquidity buffers.
Banking associations in both countries had wanted liquidity buffers to be sized so they only cover interest payments for one year netted against mortgage payment inflows.
But, much to their chagrin, regulators opted for a cautious form of liquidity buffer that covers principal payments and interest rate payments for 180 days netted against mortgage payment inflows.
Without having liquidity to cover principal payments, there is less cash in the buffer. This increases the probability of maturities being extended if a bank becomes insolvent.
But piling the liquidity buffer full of cash to make the bonds safer comes at a high cost, not least because the collateral is likely to be negative yielding.
This would put German and Swedish issuers at a competitive disadvantage to those from countries using less conservative buffers that only contain enough cash to cover net interest payments.
To some extent, Fitch and Moody’s give credit for the more conservative liquidity buffers, but S&P doesn’t and, more importantly, neither do investors.
All buyers care about is whether bonds are eligible for the ECB’s purchase programme. If they are, they know the central bank will place an order worth 40% of the deal’s size at launch and will continue buying it in the secondary market until it owns 70% of the issue.
With a big buyer like that, who cares about what may or may not happen at the maturity date?
A bond’s risk weighting, its liquidity coverage ratio treatment and central bank repo treatment are the next most important factors.
For example, Royal Bank of Canada’s 20% risk weighted bonds that count towards LCR level 2A can’t be priced in line with DNB Boligkreditt’s 10% risk weighted bonds that are eligible for LCR level 1A.
With less bank investor demand, RBC’s €1.25bn 10 year issued on January 19 attracted demand of €1.3bn from 47 investors and has since widened 1bp, whereas DNB’s €1.5bn 10 year, issued less than a week earlier, attracted a €3.3bn book from 98 investors and tightened 3bp.
Issuers from outside the eurozone are under no obligation to transpose the EU’s directive, but they most likely will if they want regulatory equivalence.
This means that Norwegian, Canadian and UK soft bullet issuers, for example, will probably change their programmes and add liquidity buffers. But they will not be rewarded for it.