Issuance patterns over the past year have shown that the covered bond market has moved ahead of political timetables, with international issuers responding to demand for non-euro covered bonds before politicians have passed relevant legislation.
The first six months of this year saw €162bn of total benchmark covered bond issuance in euros, US dollars, sterling, and Australian dollars. This is 31% more than the previous most active first half, in 2007. The equivalent figure in the first half of last year was €122bn.
"Around half of the increase is due to the traditional euro market, but the rest is coming from new markets of US 144A, sterling and Australian dollars," says Andrew Porter, global head of covered bonds at HSBC.
"The success of the product can be an important catalyst for domestic legislators to see how well it works for international issuers and so question why they should disadvantage local banks."
High hopes for US domestic participation
Benchmark dollar issuance has hit $16.5bn so far this year, according to Dealogic. Nordic and Canadian issuers have been most prominent, but large global names such as Credit Suisse and HSBC also made their debuts in the 144A format this year. On July 26, amid the throes of the eurozone debt crisis, Bank of Nova Scotia demonstrated the resilience of the dollar market, issuing $2bn of five year notes on the back of a $2.5bn book.
The favourable cross-currency basis swap for non-US issuers since early 2009 has been crucial in stimulating the interest of international issuers in the US.
"The premiums paid by European issuers for the last two years have been lower than the knock-on positive effect brought by the cross-currency swap level," says Alexandre Trulli, head of high grade/covered bond origination for the Americas at Natixis.
While international issuers have taken advantage of growing demand by issuing in 144A format, US domestic borrowers are sidelined until the US Covered Bond Act is passed, a process that has made important strides in recent months.
On June 22, the House Financial Services Committee voted in favour of the bill, which means it is ready for its first airing on the floor of the House of Representatives.
Crucially the committee voted against two amendments proposed by congressman Barney Frank which would have given the Federal Deposit Insurance Corporation the right to oversee covered bond programmes, so the bill moves on in an investor friendly state.
"We’ve had two years of discussion, staff people are pretty well informed, and the vote in the financial services committee was 44 to seven, which was strongly bipartisan, so I expect it to go through the House this year," says Jerry Marlatt, senior of counsel at Morrison & Foerster LLP.
The biggest hurdle remains the majority Democrat Senate, where FDIC concerns will get a sympathetic hearing and where a covered bond bill has never been introduced.
The bill’s progress to the House floor does not mean the FDIC’s concerns about structural subordination of depositors have been allayed. Marlatt believes a compromise could be reached by putting covered bonds on an equal footing with other secured financing, such as repo financing and home loan bank advances.
"It makes sense to put covered bonds on an equal footing because we’re talking about long term funding ratios," he says.
"It’s important to have longer term funding than repo agreements and home loan bank financing, so from a policy point of view it makes sense."
The FDIC’s demand that it retains the power to repudiate could be granted, Marlatt says, as long as the counterparty is entitled to receive sufficient funds to find an equivalent instrument in the market place.
Whether investors would accept equal status as other secured financing as adequate is uncertain. "It’s difficult to see how a US covered bond sector could develop unless the legislation was very clear as to how the cover pool assets will be maintained for the benefit of investors in the event of FDIC intervention," says Porter.
Rating agencies will be cautious about assigning triple-A ratings to issuers unless they have a 100% assurance that in the event of bankruptcy assets will be transferred to covered bond holders without any uncertainty, says Trulli.
A sub-triple-A market can develop in the US, but not immediately, he says. "If big banks open the market fully, it will automatically open the door to tier two players in the US — but it’s a question of premium and spreads in the market versus GSEs, which are a tremendous competitor to all banks."
Nonetheless, US legislation would allow hitherto sidelined US borrowers to access the market, providing another source of funding for the housing market on top of the government agencies. "This product could be a good fit, killing two birds with one stone, by reducing pressures on the GSEs’ balance sheets and giving another funding tool to the US banking system," says Trulli.
The 4% cap limit on covered bond issuance in the proposed legislation provides an indicator of how much of the housing market could be funded through covered bonds.
"The potential market could be up to 10% of overall housing market in the US," Trulli says.
"When agreement is reached with the FDIC on how the market would operate, we think the top four players could raise a minimum of $50bn over the next couple of years."
But a legislative framework will also vastly increase the pool of investor capital eligible for covered bond notes. While the largest institutional investors are already buying in the 144A format, Porter says only a small subset of the total portfolios they manage can have 144A covered bonds. Legislation would remove those limits.
The other important change would be the inclusion of covered bonds in US indices — including the all-important performance benchmarks, from which 144A format deals are excluded. The inclusion in US indices will also help international issuers.
"It will mean more of the US investors becoming comfortable with the covered bond sector as a whole. And they can still decide to buy non-index 144A issuance based on either higher spreads or better quality relative to bonds in the index," Porter says.
Kangaroo covereds bounce back
After more than three years without a Kangaroo covered bond, Canada’s CIBC re-opened the market in October 2010, selling A$750m of three year notes at 48bp over mid-swaps. Since then, there have been five more benchmark Australian dollar covered bonds.
"While it’s taken a bit of time for that market to re-establish itself, I think it’s evident that people like the structure and the various safe haven qualities of the covered market in uncertain times," says Dean O’Hara, head of fixed income syndicate at UBS in Sydney.
"It’s very likely you’ll see more transactions from more borrowers in the second half of this year and into 2012."
Australia is another jurisdiction where international issuers have found a receptive investor base, but where local banks are locked out of the market until a covered bond law is enacted.
That is set to change. Australia’s government announced in December last year, as part of wider banking reforms, that it would introduce legislation to allow banks, credit unions, and building societies to issue covered bonds.
A treasury spokesman said on August 17 that legislation could be passed in parliament by November and become law before the end of the year.
Year to date issuance in Australian dollars stands at A$4bn, including large allocations to Australian investors, which shows there could be a domestic market for Australian issuers. But it is the international investor bases, which have developed familiarity with the Australian market through senior unsecured and RMBS issuance, that could really unlock Australian supply potential.
"Australian issuers could consider accessing any of the markets in which they’ve been funding on a senior unsecured basis," says Andrew Porter.
"In the US, the Australian banks have already established a strong brand — investors have senior unsecured lines open already and, given previous RMBS issuance, a good understanding of the Australian housing and mortgage markets."
Investors in Asia Pacific have shown greater interest in buying covered bonds across currencies, and Australia is no exception.
"It’s no great secret that Asian central banks have been stalwarts of SSA market activity in Australia for a long time, so logically you’d conclude they’ll become a growing buyer of Kangaroo covered bonds over time," says O’Hara.
Another prominent part of the banking reforms announced last year was a commitment to continue the government’s RMBS purchase programme, which was crucial to that market weathering post-2008 difficulties. So far the two instruments have been able to co-exist without trouble, though it has helped that issuance in Australian dollars has been exclusively international so far.
"RMBS and covered bonds are cohabitating in this market well, and I think people acknowledge the risks and differences between the two products," says O’Hara.
Australian covered bond practitioners also want the Australian Prudential Regulation Authority to reconsider its decision not to include covered bonds in the second tier of liquid assets under new rules.
The regulator’s latest announcement in July affirmed that, for now at least, only tier one assets — cash, balances held with the central bank, and sovereign and state debt — would be deemed liquid assets. There is scope, however, for definitions to be broadened in the future, depending on market conditions.
"The regulator’s statement said it’s up to the market to prove its liquidity, so the more deals we can see the more pressure that puts on the regulator to make those changes," says O’Hara.
Canadian borrowers
Canada’s covered bond legislation is also nearing approval, but the goals behind the new law are different from the US, where the priority is to open up the market for domestic borrowers. Canadian banks already use covered bonds for international funding and diversification.
This year to date they have issued nearly $11bn of covered bonds, according to data from Dealogic, most of which was in 144A format or Australian dollars, winning investors’ confidence with healthy balance sheets, insured mortgage collateral and a healthy sovereign.
The legislation is aimed at giving investors certainty on their claim to the cover pool in the event of issuer insolvency, and Canadian issuers predict this will expand the investor base further.
"It will provide greater clarity for all investors around how a liquidation scenario will be managed and how assets that form part of the cover pool are ringfenced by law," says Chris Hughes, head of treasury at Bank of Montreal.
The fear of being left behind by other jurisdictions is an important driver. "The likelihood is that the global standard for covered bonds will be something based on legislation, and we wouldn’t want to find ourselves disadvantaged as the only jurisdiction issuing under the contractual framework," says Wotjek Niebryzdowski, vice president, treasury, at Canadian Imperial Bank of Commerce.
The introduction of legislation is unlikely to change the preference of Canadian banks to issue covered bonds internationally and the senior market in domestic terms. "We believe legislation will support the raising of covered bonds in the international markets," says Hughes.
Moody’s delivered its verdict on the draft legislation in May, saying it "would be credit positive for investors" because the legislation supports the segregation of the cover pool and requires public disclosure of periodic third-party audits. The rating agency’s main criticism was a proposed 10% limit on over-collateralisation, which would reduce an issuer’s ability to support its covered bonds to maintain a credit rating.
The law will allow any bank to issue covered bonds, though in practice the administrative expenses in creating a programme and monitoring cover pool data might put off smaller banks. The legislation is also limited to financial institutions that are federally regulated, which means banks such as Caisse Centrale Desjardins du Quebec that have already issued covered bonds, will not benefit.