Covered bonds have a lot in common with sharks — both have remained near enough unchanged for an incredibly long time. However, last week, UK lender Paragon Bank showed there is still room for innovation as it sold the first deal secured solely against a pool of buy-to-let mortgages.
For the most part, covered bonds are secured against residential owner-occupied mortgages or public sector loans, with a smattering of commercial real estate sprinkled in.
There are, of course, ship-based programmes in Europe and some banks have in the past sold deals secured against planes or renewable energy infrastructure, but these structures never garnered the same traction their mortgage-backed cousins did.
But last week’s Paragon outing showed issuers and investors in the debt market’s living fossils are not as resistant to change as first thought, at least when it comes to novel mortgage-backed cover pools in the UK.
Paragon raised £500m of three year debt to refinance a portion of its buy-to-let mortgage portfolio last Tuesday at a spread of 60bp over Sonia. Demand for the deal reached £1.4bn at the final terms as investor flocked to the deal.
At 2.8 times covered at the final terms, this was one of the most popular sterling deals since January 2023, according to GlobalCapital’s Primary Market Monitor, despite the untested novel cover pool.
Of course, it helped that Paragon offered a little more spread over its prime UK residential mortgage peers. But even then, despite the 10bp-12bp premium, the deal still offered a saving compared to other forms of financing, like RMBS.
Although GlobalCapital argues that the rise of the BTL covered bond suggests that regulators are getting the risks of RMBS all wrong, securitization regulators can remain wrong for a lot longer than issuers can remain unfunded, to tweak a famous old saw of the financial markets.
Issuers should take the most pragmatic route, although there are still some rules to be navigated.
Like with most innovations in the bank bond market — remember sustainability-linked bonds? — there are regulatory hurdles that must be overcome if a product is to breakthrough into the mainstream.
Article 129 of the UK Capital Requirements Regulation (CRR) states compliant covered bonds can only be secured against mortgages below a certain loan-to-value ratio, that are regularly valued, or guaranteed public sector loans.
However, despite the unusual collateral, Paragon’s deal complied with these regulations. The bank ensured that its deal was as close to a ‘traditional’ covered bond as possible, meaning investors had less to get their heads around.
According to the Bank of England, buy-to-let mortgages account for a fifth of the UK mortgage market. As of 2023, there were almost £300bn of buy-to-let mortgages outstanding in the UK — but only a handful of UK issuers allow them into their cover pools, with most capping the share.
If an issuer can make it work, then such a deal could prove a valuable part of their funding mix. And throwing buy-to-let mortgages into the cover pool en masse could be the place to start.
Investors have shown they like the product — at least in the UK. Covered bonds can offer cheaper funding for issuers compared to their RMBS cousins — and for right or wrong, better regulatory treatment for investors. Both would be remiss not to seize the chance and pick up the baton from Paragon.