Aussie covered bond market mixes expectation and trouble

Euroweek, February 2012

The launch of the Australian covered bond market has been a curious mixture of great expectations and teething trouble. There’s still a great deal of potential for it, but nobody would pretend it had the best of starts.

Covered bonds make a great deal of sense for Australian issuers. The Australian banking sector is one of the strongest in the world; the banks got through the global financial crisis (or the GFC, as it is universally called in Australia) largely unscathed; and they inhabit one of the strongest economies in the developed world, underpinned by China’s thirst for commodities. Only Canada really compares. Australian banks have continued to pay dividends throughout the last four years of volatility and are also aided by a national love of property ownership that makes default levels on mortgages extraordinarily low.

It sounds the perfect constituency of borrowers to go to international investors who are sick and tired of European and American banks lurching from one bad decision and toxic loan book to another. And Australian banks are big wholesale funders: adding another string to their bow in terms of funding options has a lot to recommend it.

Consequently, when the enabling legislation to allow Australian banks to go ahead and issue covered bonds passed parliament in October, after a year or so of Aussie banks practising through Kiwi subsidiaries in the newly opened New Zealand covered bond market, there were very high hopes.

But the first deals went badly. It was not entirely the fault of any of the Australian banks: October was no time to launch a new capital market. Sentiment around European sovereign debt was moving from bad to worse, and the markets were in the sort of mood where panic selling was a real possibility. But it was also not a market to push for the last basis point available. Nevertheless, ANZ and Westpac set out in November with some tough expectations on pricing.

From the issuer perspective the deals were fine, raising $2.25 billion between them, but swiftly traded down. Before long they were 40 points wide of re-offer. One banker not involved in either deal fumed that they had “blown up the market before it even started.” Investors did not get the safe-as-houses experience they had hoped for, and instead swiftly lost money. Ted Lord, managing director at Barclays Capital, put it like this. “Investors were disappointed by the spread widening seen after the launch of the first Australian covered bond issues. These investors have strong confidence in the Australian banking system, but they thought that the pricing pushed the envelope a bit too much – especially for inaugural covered bond deals from an inaugural covered bond market.”

Commonwealth Bank of Australia and National Bank of Australia promptly postponed their own planned deals in the fallout.

Still, from those unpromising beginnings, things look a whole lot better at the start of this year. Switching their focus from euros to dollars, both CBA and NAB launched successful issues in the first week of the year, with CBA raising Eu1.5 billion and NAB raising Eu1 billion the following day, both of them through five year deals. Better still, they didn’t fall in the aftermarket.

“We’ve kicked off this year with a better backdrop,” says Andrew Duncan at HSBC in Sydney, referring to promising suggestions from the European Central Bank and some modestly improved data. “The European investor base is the home of covered bonds, and it welcomed the product: there were over 120 investors in the CBA trade. It’s a strong start to the year and sets up a good platform in euros for more issuance in Aussie covered.”

That’s just as well, because if the banks had torpedoed both euros and dollars in the space of two months there wouldn’t have been many with positive words for them. It will be interesting to see how ANZ, expected to follow with a deal in euros, approaches pricing.

Investment banks in particular will be keen to see a viable source of funding develop, as the potential rewards are high. More or less every major name got a stake on one of the first four deals: Citi, UBS and Nomura on the ANZ deal; Barclays Capital, Bank of America Merrill Lynch and Nomura on Westpac; BNP Paribas, HSBC and RBS on CBA; and Credit Suisse, Deutsche and JP Morgan on NAB (all four deals were also joint self-led). They will be keen to remain involved in subsequent deals, in the hope that there are plenty of them. The Australian Prudential Regulatory Authority (APRA) allows a ceiling of 8% of total system resident assets to be issued in covered bonds for each bank. Fergus Blackstock, head of debt capital markets at UBS in Sydney, says that theoretically equates to A$160 billion just for the major banks, “if they maxed out capacity. But everyone will maintain a slight buffer inside that, which brings it down to about $120 billion.” He expects to see about A$5 billion of issuance per major bank per year.

“The expectations are high, and I think rightly so,” says Duncan at HSBC. “There is a lot of support globally for Australia and there is clear appetite there.” Though his bank was on the CBA deal, the biggest and arguably most successful of the four to date, he is forgiving about the problems faced by dollar deals. “The US dollar covered bond market is still in its infancy and the initial deals faced challenges with regards to the broader backdrop. It was the timing of the legislation and the adversity in the market that made it a difficult period to launch the product. But a lot of very diligent work has been done by the Aussie sector with regard to pounding the pavement and introducing the product.”

This is an important point: the rest of the world’s investment community is not as au fait with Australia’s bank strength as Australians sometimes believe, and throughout the deals there have been detailed questions around collateral, cover pool and credit.

The fundamentals that people hoped for the market haven’t gone away. “People are keen on the product and the jurisdiction,” Duncan says. “The structure is best in class, the legislation is robust and comparable to the best around the world; it ticks all the boxes.” And Lord, speaking before the CBA deal, says that just because early deals didn’t go well, there’s no reason this can’t be a long-term successful market. “Australia has the potential to be a large market of covered bond issuance and offer a high quality diversification that many investors are seeking,” he says. “The Australian covered bond market can be a strong pillar in the global covered bond market in 2012.” But for that to happen, Lord will like to see the banks collaborating a bit better with one another for the benefit of the broader market.

If future deals continue to go well, then Australian banks can look forward to a new addition to the toolkit alongside 144a, samurais, domestics and European MTNs, in all of which they boast a more than decent track record. That, in turn, improves still further their relative strength as a sector. Banking is not what it was anywhere in the world, but in Australia, it’s not such a bad time to be a bank.

BOX: Asset-backed

Securitizations in Australia are not the most vibrant part of the market; they plod along, but are no longer a source of great innovation or volume. That said, they also don’t default – there’s a lot to be said for simplicity.

“The Aussie market has functioned through the crisis – it’s one of the few jurisdictions that has – but it’s not in the same quantum that it was prior to the GFC and sub-prime,” says Andrew Duncan, director of debt capital markets at HSBC. It is a market dominated by residential mortgage-backed flow, which is no surprise in a market in which property investment and ownership is very much a mainstay of individual aspiration; other classes like credit cards and auto finance are much less vibrant here.

The banks – not just the big four but the regionals too – continue to be active in Australia, and are aided in doing so by the Australian Office of Financial Management. In 2008 this office, backed by the state, was directed by the Australian treasurer to invest directly in Australian RMBS in order to support competition from smaller lenders at a time when funding markets were challenging. It did so twice in October 2008, then again in November 2009. Initially it looked like that would be enough, but in 2011 treasurer Wayne Swan decided to keep AOFM active. “While this program is making RMBS funding economic for smaller issuers, pricing levels and issuance volumes have not yet improved sufficiently to accommodate new issuance from a variety of smaller lender without AOFM support,” he said in April, and directed AOFM to invest an additional A$4 billion in Australian RMBS, plus A$3.463 billion left over from previous directions, bringing the total investment by the government since the financial crisis to $20 billion.

It appears that AOFM is going to be a fixture in the asset-backed markets for years to come. “I’d expect that to continue,” says Duncan. “Is it critical on all transactions? No, there have been transactions without their investment. But for the smaller guys, it’s been valuable.”