BPE’s most recently issued €1.5bn March 2022 was indicated around 62bp over mid-swaps at Tuesday’s market close, some 26bp inside the reoffer spread and in stark contrast to its additional tier one bonds, which hit a then-record low of 52.64 on Tuesday.
By Wednesday, when news of the bank’s resolution and sale had emerged, the covered bonds were trading at 9bp over mid-swaps, representing a pick-up of about 10bp to the covered bonds of the bank’s new parent, Santander.
The steady performance until Tuesday’s market close was in part helped by the technical factors supporting covered bonds — and particularly Spanish deals. With the highest amount of redemptions of any European jurisdiction, and only two benchmarks issued so far this year, net negative issuance is at its highest in Spain.
That means the Eurosystem has been forced to meet its covered bond purchasing target by buying in the secondary market and probably absorbing sales of BPE’s covered bonds.
Central banks originally bought 34% of this deal when it was issued a little over a year ago and it is likely that that proportion has gone up.
The fact that practically no volume has traded in the past couple of weeks may be because bank traders are reluctant to bid for paper and investors have no inclination to crystallise a loss. But it could also be because sellers that wanted to get out of this name have already done so.
Those trades are more likely to have happened in late April, when BPE’s covered bonds were downgraded by Moody’s from Aa2 to A2.
As a consequence, bank investors will have been obliged to hold double the capital against their exposure as the risk weight will have jumped from 10% to 20%, damaging their return on regulatory capital and making their investment far less palatable.
But assuming all the banks that bought into this deal had sold their positions, about half the transaction will have remained with other private sector investors, such as asset managers, which are not affected by the change in risk weight. The fact that they have held on to their exposure probably came down to their fundamental confidence in the product.
With an overcollateralisation ratio of 162%, it is difficult to see how, before the resolution, the covered bonds could have been downgraded by a further five notches to sub-investment grade territory, where these bondholders would be obliged to consider a forced sale.
But even in the unlikely event of a downgrade to junk, history has shown that Cédulas ratings bounce back. It should be a source of comfort for investors to know that the Bank of Spain has safeguarded covered bond investors ever since the Spanish real estate market popped almost a decade ago.
Its consistent approach to bank resolution stands in contrast to the way regulators in Austria and Portugal managed the respective resolutions of Hypo Alpe Adria Bank and Banco Espirito Santo. And, thanks to early state intervention, the Spanish banking sector has not been affected by the same systemic wobbles as Italy.
Spanish banks may not have issued much Cédulas this year, but at around €350bn outstanding the sector is too systemically important for the central bank to ignore. In practice, Spain’s weaker banks have been absorbed by stronger names. That means bond holders, who may have seen their investments turn to junk but rode out the downgrade, will have ended up holding bonds from a bank with a higher rating than when the deals were launched.
The biggest potential problem is the mark-to-market gyrations that could have followed another round of negative headlines. But even if a big buyer such as Santander had not emerged, there was always going to be a high probability that investors would have been redeemed in full and on time.
With the assets excluded from a potential resolution of the bank, along with investors’ second claim against the bankruptcy estate of the issuer, there is a lot of legal protection in the structure.
Which all goes to show that the inactivity in BPE’s covered bonds until Tuesday’s close may well have reflected bid-side illiquidity, but it also underscored some fundamental and technical truths.