27 September 2016
By Guenther Scheppler, CEFA, Senior Covered Bond Strategist, DZ BANK
The vote in favour of Brexit by the British people marks the start of a journey into the unknown, particularly for the United Kingdom (UK). Depending on future developments in the UK, the country’s covered bonds may also be affected by the changes. An economic downturn could have a negative impact on the quality of cover pools. New, alternative refinancing options for covered bond issuers could also lead to an increasing contraction in the volume of outstanding UK covered bonds, and the segment could thus decline in importance.
In the referendum at the end of June, a majority of the British (52% of those who voted) voted to leave the European Union (EU). Will the country now definitely exit the EU? Not necessarily, since the result of the referendum is not binding for the British parliament. However, none of the elected representatives will seriously want to risk not carrying out the will of the people. Brexit will therefore presumably go ahead. The new Prime Minister, Theresa May, has also already signalled that “Brexit means Brexit”.
Meanwhile, the timescale remains uncertain. Under Article 50 of the EU treaties, the UK must first of all officially inform the EU of its plans. After this has happened, withdrawal negotiations must be completed within a maximum of two years. The negotiating period will be the really interesting time.
In any event the British government wants to maintain very close economic links with the EU. For the EU the UK has always been an important trading partner in the past. Nonetheless, the negotiations will be anything but easy. If the trade links between the EU and the UK alter only slightly after Brexit, this could trigger referendums in other EU countries and that could lead to more withdrawals. Conversely, if the EU takes a very hard line and more or less severs all preferential trade relationships with the biggest island in Europe, this could have undesirable economic consequences for both sides. Given the forthcoming political balancing act, forecasts about the future outcome for the UK are very difficult.
Possible alternatives for future relations between the EU and the UK are a free trade agreement, or the “Norwegian model”. As a non-EU country, Norway does have virtually unrestricted access to the EU single market but it has to pay for the privilege by contributing to the EU budget. If a free trade agreement or a model similar to that of Norway cannot be achieved, the UK will be at risk of losing access to the EU single market. If this were to happen, import and export duty would probably be imposed on UK goods, leading to a decline in demand for British products in the EU. Foreign investors who previously regarded the UK as the “gateway to the EU single market” could have second thoughts when deciding where to locate their operations. Second round effects could then be expected to include a steep economic downturn, an increase in unemployment and a visible decline in property prices. At this stage, there would also inevitably be an impact on the cover pools of British covered bond programmes.
If house prices were to spiral downwards, this could have a negative medium-term impact on the credit quality of the mortgage books of British banks and their credit profiles. So long as the relevant issuer ratings for UK covered bond programmes do not deteriorate dramatically, it should be possible for issuers to maintain their current covered bond ratings, although higher over-collateralisation ratios might be required than at present. On the other hand, if Brexit leads to downgrades of two to three notches or more for the issuer ratings of UK banks, based on the agencies’ rating models this would automatically trigger the first rating downgrades for some UK covered bond programmes. The spreads of the corresponding UK covered bonds would then subsequently widen disproportionately compared to their direct peer group.
At this point, the question which needs to be asked is what constitutes the direct peer group for British covered bonds at that time. By answering this question the issue of whether the UK remains a member of the European Economic Area (EEA) plays a crucial role. If the EU agrees with the UK to base the future economic relationship on the Norwegian model, the cover pools of British covered bank bonds could continue to meet the criteria of Article 52 (4) of the UCITS Directive, or respectively of Article 129 (1) of the CRR. One of the advantages of this would be that UK covered bonds could still qualify for the Level 1 category within the Liquidity Coverage Ratio (LCR) in future. The risk weighting of the bonds would not alter either. In this scenario, the peer group would consist mainly of Norwegian covered bonds.
Conversely, if the UK is no longer a member of the EEA, the covered bank bonds of British issuers would also no longer meet the UCITS/CRR criteria and could thus only qualify for at maximum the Level 2A category of the LCR. Their risk weight would increase from 10% to 20% under the credit risk standard approach. UK covered bonds could nevertheless still be used as collateral for refinancing transactions with the European Central Bank, since the UK is one of the G10 countries, similar to Canada. The spread levels of Canadian covered bonds could then act as a good benchmark for the future valuation of British covered bonds. However, if the ratings of British banks are downgraded to a significant degree, the corresponding covered bonds could be expected to continue to trade on average at a risk premium to their Canadian counterparts, whose issuers all currently have ratings in the AA sector.
An expected shortage of British covered bonds should most likely have a braking effect on a spread widening trend. Looking ahead to the maturity of British covered bank bonds in the coming years, there is a very high volume of EUR 21 bn in 2017. In the three subsequent years, the average figure is still a good EUR 10 bn. Based on forthcoming
maturities, there will certainly be a refinancing requirement.
However, it is unclear at the moment how many of the maturing UK covered bonds will in fact be replaced with corresponding new bonds. Issuers currently have the option of several attractive refinancing channels for their mortgage business. The Term Funding Scheme (TFS) launched recently by the Bank of England also offers UK banks a very flexible and low-cost means of refinancing for their mortgage business. Since the maximum term of the TFS is limited to four years, new UK covered bond issues at the short end of the maturity curves are likely to remain in short supply until the TFS is concluded, as currently projected, at the end of February 2022. British banks can also refinance their mortgage business by selling traditional Residential Mortgage Backed Securities (RMBS), with the added advantage of removing mortgage risks from the bank’s balance sheet via true sale. The actual future funding requirements of the British banks are also unclear, given the ongoing contraction of balance sheets.
Even if, as indicated above, the expected decline in issuing activity in the British covered bond segment does act as a brake in a phase when spreads are generally widening, there is the other side of the coin: the segment will continue to decline in importance relative to the global covered bond market. Whereas, in 2008, British covered bonds still had a global market share of 8.9%, the figure has fallen in recent years to 4.9% (2015). We expect the market share to continue to decline in the years ahead. The UK covered bond segment will nonetheless remain important in future, since it has been one of the driving forces for many useful innovations over the years.
This article was originally published in the July-August 2016 edition of the EMF-ECBC Market Insights & Updates Newsletter. Please note that any views or opinions expressed in this article are those of the authors and not necessarily those of the EMF-ECBC. This article does not constitute investment advice.
The impacts of Brexit on covered bonds was one of the topics discussed at the 24th ECBC Plenary Meeting in Düsseldorf on the 14th of September 2016. The two videos below present the highlights of the discussions: