UK covereds to feel heat from Brexit

By Alice Gledhill

LONDON, June 28 (IFR) - The favourable regulatory treatment of UK covered bonds under European Union laws could come to an end following Brexit, potentially reducing investor appetite and pushing up funding costs.

Covereds not only provide a key source of cheap funds for UK banks but have also proved the most resilient funding tool in times of stress.

But the prospect of losing preferential treatment under EU laws means they could lose value in the eyes of bank treasuries that buy them for liquidity portfolios.

An exit from the European Economic Area could see UK covered bonds lose their prized Liquidity Coverage Ratio level 1 status, dropping to level 2A along with other non-EEA jurisdictions.

"The worst-case scenario would be that UK covered bonds are treated in line with Canadian, Australian, New Zealand or Singapore covered bonds," said analysts at Societe Generale (Swiss: 519928.SW - news) .

UK institutions issued 13bn-equivalent in 2015 and another 7.3bn-equivalent year-to-date, according to IFR data.

Any prolonged uncertainty could prove punishing for UK banks if investors give the asset class a wide berth.

"The worse thing you can do is load up now while they're cheap, to then become a forced seller," said a banker.

It might be early days but the potentially large impact means there is cause for some concern, he said: "There may be enough investors to do deals, but they may be smaller deals."

UK covereds have underperformed other jurisdictions since Thursday's vote and were seen up to 8bp wider on average - a significant move for the normally safe and steady market. Peripheral covereds are around 6bp wider.

A Lloyds 1.5bn Jan 2021 is bid at mid-swaps plus 23bp according to Tradeweb, wider than CBA Feb 2021s at plus 9.4bp. Lloyds is 8bp wider than last Thursday, CBA just 1bp wider.

COUNTDOWN

Credit considerations for UK covereds should however offer some support.

"While downgrades cannot be ruled out entirely, a moderate economic deterioration should harbour no major credit risks for UK banks," Commerzbank (Xetra: CBK100 - news) wrote in a note.

UK covered ratings should be able to withstand sterling depreciation or a sovereign downgrade, S&P said earlier in June. Fitch and S&P have both since downgraded the UK to AA (negative).

Bankers expect covereds to continue as a reliable source of funding for UK institutions and said that while parts of the buyer base might be cautious, different investors take different views.

"Depending on timing and final outcome of the upcoming political discussion between the EU and UK, we foresee a phase of heightened uncertainty for primary market windows," an investor said.

"Combined with the view on the potential future business possibilities of UK banks in general, we are cautious on UK banks. Nevertheless, covereds could be the only available wholesale funding source for UK banks."

Front-loading by UK institutions and additional Bank of England funding mean they are well positioned to sit out the short-term uncertainty, but not indefinitely - particularly since covered bonds are likely to offer the easiest route back into the public debt market for UK banks.

"I'm not sure everyone can afford to sit out for the rest of the year," said the first banker.

(Reporting by Alice Gledhill, editing by Helene Durand and Julian Baker)