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Banks' Massive Debt Splurge Brings Its Own Set of Dangers

(Bloomberg) -- As European and British banks race to repay giant Covid-era loans, they’re having to lean ever more heavily on selling new debt to cover the cost. That flood of supply brings its own dangers.

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With lenders facing about €250 billion ($271 billion) of repayments to the European Central Bank this week, many are turning to so-called “covered” bonds — debt that’s backed by assets such as mortgages — to help fill funding gaps. Rampant demand for corporate credit right now means banks have been able to use these sales to partly replace cheap pandemic loans.

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But some market participants wonder whether the asset class may be nearing a saturation point, and worry what will happen if the current euphoria for all types of corporate credit starts to fade. Hedge funds have piled into the bonds, too, creating anxiety about banks having to depend on so-called “fast money” and on the robustness of the assets securing the debt.

The supply gusher has become so extreme that buyers may risk hitting “limits on how many covered bonds they can buy from a single issuer,” according to Maureen Schuller, head of financials sector strategy at ING Groep NV. Lenders could have to shift to selling senior unsecured bonds, she says, a more expensive type of finance, adding that “banks need to diversify their funding.”

Last year, European banks sold a record $227 billion of covered bonds, and notched up a monthly record of $52.5 billion in January. Barclays Plc analysts expect a bumper 2024, forecasting up to €210 billion ($228 billion) of sales.

The funding issue is particularly acute because the ECB and Bank of England are trying to manage the end of their cheap loan programs — which aimed to keep investment flowing into businesses and households — without putting borrowing banks under strain, or draining their liquidity. So far the exercise has gone reasonably well, with hundreds of billions of euros repaid last year.

Being able to tap the strong demand for covered bonds has helped. These issues have become wildly popular because they’re secured by real assets, making them in theory some of the safest corporate debt around. And the glut of supply means banks are having to offer interest rates of about 3% on average, according to Bloomberg data, to keep buyers happy.

Norway’s Eika Boligkreditt this month had a whopping order book of €3.4 billion for a €500 million covered-bond issue, after high levels of demand for sales by BPER Banca SpA and Credit Agricole Italia. Virgin Money UK Plc issued £500 million of residential mortgage-backed securities in January and expects to issue as much as £1.5 billion more notes this year, dependent on needs.

But the huge size of the Covid loan repayments means regulators are having to stay vigilant. “At the moment I don’t lose sleep over it as the market’s wide open,” says Filippo Alloatti, head of financials at money manager Federated Hermes. “The main concern is if the markets close. If that were to happen, the central banks may have to swiftly introduce a liquidity scheme.”

The last of the big ECB loan programs (known as TLTROs) will still have €141 billion to recoup after this week’s installments. The BoE’s similar TFSME plan was owed about £145 billion ($183 billion) at the end of December, or about 7% of banks’ lending, according to RBC Capital Markets analyst Benjamin Toms.

British lenders are due to repay most of this by the close of 2025. So-called “challenger” banks, smaller UK firms such as Virgin Money, were some of the biggest users of these facilities. Most will try to refinance before the end date to avoid a “cliff edge” of large and sudden changes to their funding, Toms adds, but replacing the money will be a bigger issue for some.

On the ECB loans, Italian banks had €141 billion in outstanding TLTROs set to mature in 2024, the highest across countries, according to a recent note from ING’s Suvi Platerink Kosonen. France had €96 billion, and Germany €69 billion.

Unfree Money

The stampede into covered bonds comes as banks adjust to a new era where money that was almost free before now carries a cost. Lenders have several options for other funding, including bonds, cheap short-term money from central banks or lifting deposit rates to try to get customers to leave more cash in their accounts. But they have to weigh up the extra expense.

Read More: ECB Policy Revamp Locks In Rates Floor System

Although covered bonds are among the cheapest financing available to banks, their 3% average yield is much higher than near zero. “Highly rated assets are still in good demand,” says Kaspar Hense, a portfolio manager at RBC Bluebay, adding that the plenitude of supply will keep the interest cost relatively high.

Regulators have also questioned the massive leverage being used by some hedge funds when making wagers on certain asset-backed bonds, such as mortgage-backed securities.

Hense says it’s “extremely important” for investors to understand the assets underlying each bond, especially property. “Commercial real estate certainly remains a poster child for stress,” he concludes.

Elsewhere in credit:

Corporate Bonds Are The Safest They’ve Been in Almost a Decade

Altice France’s Investor Call Spurs Week of Frenzied Bond Trades

FTX Crypto Creditors Fight Claim That ‘Sam Coins’ Are Worthless

Turkish Banks Sell AT1 Bonds as Buffer Against Volatile Lira

--With assistance from Alexander Weber.

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