ECB Watch: Covered Bond Purchases Begin

The unconventional policy in Europe, under which the central banks will buy up to 60 bln euros of covered bonds kicked off earlier this week. European officials are loath to call it quantitative easing, but exactly why it isn't, has not been explained. The ECB itself will buy 8% of the targeted amount with the national central banks responsible for the remainder.

The rules of engagement seem straightforward, but with plenty of flexibility. European central banks will buy covered bonds with AA rating or higher, but if a rating slips to BBB it will not necessarily jettison it from the portfolio. The covered bonds that will be purchased must be issued by institutions incorporated in the euro-area, which excludes covered bonds issued by the UK, Scandinavian countries and others.

Initially, it appeared that the maturities would be up to five years, but this has been clarified to 3-10 years. The central banks are thought to be looking at volume too and would ideally like to buy covered bonds issues of 500 mln euros, but the ECB for one, said it will be flexible about this too and look at covered bond issues of 100 mln euros. Some 2100 institutions will be involved in the covered bond sales to the central banks. And the covered bonds acquired will not be re-used in repo operations.

Ironically, the ECB's announcement back in May could have a greater impact than the actual purchases. According to industry indices, the spread between covered bonds and sovereign bonds narrowed from about 111 bp to 85. The spread had peaked near 130 bp. Not only have spreads narrowed, but volumes have increased, including jumbos.

Now that the market for covered bonds has re-opened, it will be interesting to monitor the aggressiveness of sellers to the central banks. There is some thought that unless the European central banks offer more than market prices for the covered bonds that the 2100 or so institutions may not have a strong incentive to sell.