The covered bond LTRO carry trade. Pretty attractive in December. Not so much now.
That at least, is the view of Leef Dierks at Morgan Stanley on Friday.
Dierks believes that even though banks will take up as much as €450bn in February’s LTRO, not much of that will go into covered bonds because the carry-trade is simply not attractive enough.
As he explained, referencing the below chart (our emphasis):
As illustrated above and depending on the name, the implementation of covered bond-backed carry trades in the run-up to the ECB’s first 36-month LTRO was significantly more attractive than is the case in the run-up to next week’s second 36-month LTRO. This is particularly pronounced in the Spanish and Italian markets, where the three-months-carry (assuming funding costs of 1.000%) has dropped by as much as 40bp in the past few weeks. In the case of the French and German market, in contrast, this move has been significantly less apparent as paper did not benefit from the same demand in light of their relatively tight spread levels upon announcement of the first LTRO.
In the case of Spain, the covered bond curve is now especially steep, something Dierks says limits the shorter end’s potential to rally much further.
What’s more, while the primary market has re-opened, it seems much of it is limited to providing custom-made, shorter-dated supply to satisfy the ongoing demand for carry trade material. Spain, in other words, has been flooded by carry-trade material, which has in itself killed the carry trade. What an irony.
Hence, if you are going to play the carry-trade, look further out the curve, says Dierks:
In the run-up to next week’s LTRO, we therefore continue to prefer covered bonds with a remaining term-to-maturity (TTM) of between three and six years, which still offer a discount of up to 100bp versus the short end of the Spanish market. We think this segment is likely to tighten versus swaps as investor demand increasingly moves out the curve in response to the short end becoming illiquid. The rationale behind this recommendation is that with shorterdated paper having rallied markedly since the announcement of the first LTRO, the appeal for carry trades has considerably declined.
Much of the same pattern applies to Italy too, he says.
Related links:
LTRO smackdown – FT Alphaville
Covered bond sales soar amid January flurry – FT