Credit: Covered bonds are heading to Asia Pacific

Credit Magazine, April 2011

Covered bonds globally have just enjoyed a record January, with Eu45 billion of supply in the European markets alone. The market grew 45% in 2010 to US$311 billion, on Thomson Reuters numbers. But what of Asia Pacific? Oddly, this part of the world – so important in global GDP and trade, and increasingly in capital market flows – has completely missed out.

But that might be about to change. In Australia and New Zealand, covered bonds – collateralized against set pools of assets on the issuer’s balance sheet which can be claimed by investors in the event of a default – are starting to appear from foreign issuers, while legislation is underway to allow domestic borrowers from those countries to start issuing them. In the rest of ex-Japan Asia, activity has been limited to a couple of experiments in Korea, but it would make sense to see several markets take a look at the asset class in a post-financial crisis world.

They do, after all, have a lot to recommend them. “For banks, they are not only a way to get cost-effective funding at a good price and tenor, but also a great way to tap into a global investor base,” says Ted Lord, managing director at Barclays Capital. “With the financial crisis, in some cases, it has been prohibitive for banks to issue senior unsecured debt. This is a good way for them to move to a more supportive market.”

Issuers launching covered bonds can expect to reach investors who were otherwise out of reach. “The central banks are typically looking to invest in safer credits, with stable secondary performance and preferably with AAA ratings,” says Sean Henderson, head of debt capital markets at HSBC Australia. “The covered bond market therefore helps issuers access these deeper pockets more effectively.

“The other buyer base that covered bonds help with are the bank balance sheets, again because of the AAA rating which makes them more capital efficient,” Henderson says. Covered bonds, he says, “are looking to be more of a rates-type instrument: lower volatility, safer, higher ratings.”

And so there’s a clear investor base to support a new market. Lord adds: “For investors, given some of the changes we’ve seen in the banking landscape, if they can get a good yield and tenor and have the bond collateralized by a bank’s best assets, it is an attractive proposition.”

Activity so far has been from foreign, and predominantly Canadian, borrowers. Covered bonds of this kind do have a pre-crisis track record in Australia, but it has only recently revived.

First, in October, Canadian Imperial Bank of Commerce launched A$750 million of three-year bonds through ANZ, HSBC and UBS, with CIBC World Markets as a joint lead without books. In January, Bank of Nova Scotia completed an A$1 billion covered bond issue through HSBC, Scotia Capital, UBS and Westpac. The Bank of Nova Scotia deal priced at 46 basis points over semi-quarterly swaps, with a yield of 5.9%; CIBC paid a 5.75% coupon and a yield of 5.89%, equating to 48bps over swaps. Both had the backing of CMHC, Canada’s national housing agency, and are secured against fully insured residential mortgage loans. “We learned [from the Canadian issues] that the engagement across the market has been a lot broader, across multiple investor types, than our initial sense,” says Dean O’Hara, head of fixed income syndicate at UBS in Australia. Both deals are believed to have gone roughly 50-50 to bank balance sheet and real money investors. “We were pleasantly surprised by the uptake from the real money side from what has traditionally been perceived as a bank balance sheet product.”

For issuers like these, it’s natural that the A$ market should be appealing: issuers see the Australian dollar as a method of diversification; there’s a ready investor base keen on the additional protection; and covered bonds are seen as an increasingly preferable alternative to asset-backed securities. On top of that, the basis swap is working in favour of Australian issuance. Spreads can be as much as 50% inside the cost of senior unsecured debt if the swap is favourable. “The Australian dollar investor base for covered bonds has been developing rapidly, including a strong local bid,” says Henderson. “With the CIBC and BNS trades there was a pretty intensive education process among the Australian investor base, talking through the covered bond concepts, the structuring, secondary trading performance of the product, and so on.” With that education completed, there is a strong investor base ready for foreign issuers. “There is a pipeline: not exceptionally heavy, but certainly a good number of interested parties looking at issuance in Australian dollars.” Dexia Municipal Agency is also expected to launch covered bonds in Australia, as is Royal Bank of Canada.

What’s in the works now, though, is something new: Australian issuers. In December, Treasurer Wayne Swan announced reforms across a range of areas, including proposals to allow all banks, credit unions and building societies to issue covered bonds. This change was part of a broader policy called the Competitive and Sustainable Banking System reforms, which included support for the RMBS market and trading of government bonds on exchanges.

Getting to this point has taken six years, and the prompt may have been Basel III. Until now, the Australian Prudential Regulation Authority (APRA) has blocked any moves to develop a covered bond market, because doing so would have required it to change the Banking Act, and more specifically the provisions which give depositors precedence over any other creditor, including debt holders. From APRA’s perspective, they have been forced to rethink because of the increased liquidity requirements imposed by Basel 3: it is now beneficial, and perhaps vital, to increase the range of available funding sources for Australian banks.

“The liquidity requirements under the new regulatory framework for banks are going to require more and more paper,” says Pierre Katerdjian, global head of credit markets at Westpac. “Covered bonds fit into that space. There is a natural home for that product among some of the biggest fixed income buyers in this market.”

But these are not straightforward matters for regulators or parliaments. “To get covered bond legislation up and running and put the program in place takes time,” says Lord. “Parliamentarians have to understand the basis of what is being done. Don’t forget that covered bonds are great for a covered bond investor but they create a dilemma for a regulator, because in insolvency the best assets of a bank are collateralized and subject to a priority claim by covered bond investors. It means there might not be so much left for depositors or unsecured lenders.”

Fergus Blackstock, head of DCM at UBS in Australia, says that covered bonds have been notable by their absence in Australia in recent years: a market with big banks, strong balance sheets and prime assets, perfect for covered bonds, yet unable to issue them. “The deposit protection in the banking act was the big regulatory obstacle, but when markets dislocated, covered bonds proved a stable form of funding,” he says. “When you are looking at funding a banking system, you want as many avenues for funding as you can. Everyone has had another look at covered bonds in the context of the crisis.”

Suggestions are that Swan will limit covered bond sales to 5% of total Australian assets, similar to the 4% limit in the UK and Canada (in New Zealand it is 10% – see below). Some analysts believe the market could therefore be as big as A$120 billion. Nomura’s Ben Byrne has said that, at 5%, “we expect covered-bond issuance to amount to approximately one full year of each bank’s term funding requirement, or around 20%-25% of the term funding requirement on an ongoing basis.”

It’s not there yet, though. Although Swan has announced his intentions, the industry and APRA are still in discussions about how best to build a suitable framework, and the legislation must still clear parliament – not easy in a country where the government holds the slimmest possible majority, and even then only because of alliance with independents. “We think the changes to the banking act could happen in the next month or two, that piece is imminent,” says Katerdjian at Westpac. “The expectation is high that it will get through: both political parties appear to be in agreement, and if there’s a delay I expect it will be because it’s been caught up in the politics around the other broader banking regulatory changes being discussed.” Once agreed, royal ascent will take “a couple of months,” he says, and then “a covered bond framework needs to be developed in Australia, which could take another six months. But the reality is that once the Banking Act is changed, APRA may well say to the majors: go ahead and start issuing.”

Certainly, APRA is making more positive noises about the market than used to be the case, with chairman John Laker telling a Senate inquiry in December that it would work with government and industry on the proposals provided that depositors remained suitably protected. “It is early days but negotiations are very constructive and making good progress,” says Blackstock. “We don’t have a draft regulation out yet, but we expect it to be a 2011 development.”

When issuers come, they’re likely to find a receptive global audience no matter which currency they launch in. “It helps if you have strong banks, and Australian banks are among the world’s strongest. Australia’s financial system was one of the most sound coming out of the financial crisis,” says Lord at Barclays. “Do you have a fairly big mortgage market? Yes you do. Do you have many high-quality public-sector borrowers? Definitely. The ingredients are there for a promising and growing Antipodean covered bond market.”

“Domestic issuers, most people are revving their engines,” adds Katerdjian at Westpac. “They are keen to go, particularly the majors, and are just waiting for the legislative changes to go through.”

New Zealand is already one step ahead. In November, Bank of New Zealand – a unit of National Australia Bank – launched the country’s first covered bonds in a Eu1 billion seven-year deal through Barclays Capital, Deutsche, JP Morgan, RBS and National Australia Bank, and has also issued in New Zealand dollars. It instantly demonstrated the cost advantages of the asset class: at 2.125% and 62 basis points over mid-point swaps, they priced well inside the same issuer’s existing senior unsecured bonds. A seven-year New Zealand dollar bond had priced at 112 basis points over mid-swaps just a few months earlier.

At the time of writing, Westpac New Zealand was completing a roadshow to issue in euros through its Westpac Securities NZ vehicle. The issue, part of a Eu5 billion covered bond program set up last year, was expected to be rated AAA, compared to Westpac itself (AA) or Westpac NZ (Aa2/AA). Barclays Capital, BNP Paribas and UBS are leading the deal. “Feedback was very strong on the roadshow,” says Blackstock at UBS. “The market is very open, not only to this region because it had a ‘good’ crisis, but because of the diversification it is going to offer. The covered bond market is big and deep but has a lot of repeat borrowers; there is good appetite for a new jurisdiction coming on stream.”

New Zealand has set criteria for covered bond issuance from its banks, limiting issuance to 10% of total assets. The limit will be reviewed over the next two years. Grant Spencer, the deputy governor of the Reserve Bank of New Zealand, said the limit “will allow banks to develop covered bond programmes, whilst providing a conservative ceiling on issuance in the short term.”

There are, though, limits to how far the market will go. “It’s important to bear in mind that covered bonds are not apples and apples,” Katerdjian says. “The underlying ratings have to support the issues. While they will get some funding benefit from this new product, there’s not really going to be a huge direct impact for the smaller financial institutions in Australia: if you’re BBB+ you simply aren’t going to get the same ratings uplift benefit as a major AA issuer.”

And while it’s tempting to see Australian and New Zealand as the vanguard of a new wave of legislation across Asia, it should be remembered that they are something of a special case. “The Australia and New Zealand angle is slightly differentiated from the rest of Asia,” says Sean Henderson at HSBC. “Australian and New Zealand banks are all very high quality already with deep and liquid senior curves, and they fund quite a lot in the international markets. For other Asian credits, they don’t tend to issue in large volume and don’t need a significant amount of senior funding, if any at all.

“That’s why we’re seeing things develop in the Australian and New Zealand markets first: they’re going to benefit the most from accessing new investor bases, creating new depth in markets, and gaining access to bank balance sheet and central bank investors. It’s about gaining diversity, which obviously makes their funding task easier and less prone to volatility.”

BOX: Elsewhere in Asia?

Outside of Australia and New Zealand, the only place in ex-Japan Asia to have shown any interest in the development of a covered bond market is Korea. In May 2009, Kookmin launched a US$1 billion five-year covered bond issue. Then in July 2010, Korea Housing Finance Corp raised US$500 million in 5.5 year covered bonds through BNP Paribas and Standard Chartered.

For backing, KHFC used a pool of trust registered assets (25 to 30 year residential mortgages) held by the bank through statute. This differed from Kookmin’s earlier deal, which had used bankruptcy-remote vehicles, making it something of a halfway house between asset-backed deals and covered bonds in the European sense. When Kookmin issued, there was no legislation equivalent to European standards of covered bonds; since then, the KHFC Act has been passed, giving investors a priority claim on cover pool assets.

“When KHFC came out with the first statutory covered bond out of Korea it was five times oversubscribed, which shows investors want it,” says Warren Lee, global head of structured finance solutions at Standard Chartered. But while it attracted a solid book, in pricing terms it seems to have been a tougher sell. Although the deal sold around the world, 49% of it going to the US, KHFC priced at 235bp over Treasuries and 197 bp over mid-swaps for a five-year deal – not a sufficient improvement on the institution’s usual cost of funding to warrant many copycat issues. “Some investors felt that first time issuers with a legal structure that has never been seen before require a significant premium over an unsecured issue,” says Lee. “There’s some validity in that: Korea has gone through two big crises and has never tested a default scenario. But others thought it should price near the sovereign or as a quasi-sovereign, and if you look at the secondary spread today it is pricing inside where a quasi-sovereign is.”

Asian banks, though, have less of an obvious need for covered bonds than others in the world because there is so much liquidity for them already. KHFC did it in the name of opening a new source of financing, not just for itself but other Korean banks and mortgage institutions (KHFC is a state-owned entity with a public policy function). “The key reason it hasn’t developed before now is liquidity in the market,” says Lee. “In the bank sector the loan to deposit ratio averages around 70%: there’s no need to tap funding. Very few Asian banks have senior unsecured bonds outstanding because they can easily fund through bank deposits. Korea is the only exception, which is why it was the first to push out covered bonds.”

Still, he’s hopeful of more issuance. “KHFC has a program and will hope to tap two deals a year,” he says. “Once KHFC approves other Korean banks to issue, they will do the same.”

While the KHFC deal was closer to European standards than the Kookmin one, there is still a sense that the stringency in the Pfandbriefe market in particular is greater than anything that has been produced from Asia Pacific thus far.

“The investor reaction to the Korean deals shows not only that having the legislation is really helpful, but also that the investor base is looking for some sense of how the bonds fit within the overall covered bond market,” says Ted Lord at Barclays Capital. “What are the rules, what happens if there is a default, how easy is it to take control of the covered pool? They are all questions investors continually ask.”

And even if Korea builds a market, where else? Malaysia and Thailand set up task forces to look at covered bond markets two years ago but were hit by the financial crisis. Singapore could be a candidate but there is little market discussion about it. Hong Kong would be the best fit, but no issuer immediately needs it. “In Hong Kong it’s up to the banks and private sector to push this through,” says Lee. “Right now nobody has any funding needs: in Hong Kong the only worry is how you lend more money. But their local currency is rated AAA by Moodys, so they would be ideal to issue covered bonds.”

In the end, it’s usual about critical mass: one good deal leads to others. “Nothing succeeds like success,” says Lord. “It’s just a matter of time until you see more countries getting involved in this.”