On Sept. 12, the Royal Bank of Canada (RBC) pitched what some see as a game changer for U.S.-dollar covered bond issuance by foreign banks. The Canadian bank launched the very first U.S. Securities and Exchange Commission (SEC) fully registered covered bond deal — a $2.5 billion, five-year bond that priced at mid-swaps plus 35 basis points.
RBC has historically accessed the U.S. investor base only through the 144A market. The SEC registration afforded RBC approximately 10 basis points in incremental savings relative to 144A, said one person familiar with the deal.
"Compared to an RBC 3.125%, three-year covered bond issued today, with the curve adjusted from 3s to 5s and a new-issue premium tacked on, that new RBC 144A bond would have priced at mid-swaps plus 45," said the market source. "The SEC bond priced at mid-swaps plus 35, hence the 10 basis points in value for SEC registration."
There are a number of significant advantages associated with SEC-registered covered bonds, but of course the decision to register will be easiest for foreign issuers that are already U.S. reporting entities. Canadian banks have dominated U.S. dollar issuance since RBC's inaugural 2007 Canadian covered bond program. According to figures reported by Bank of America Merrill Lynch, Canadian banks account for 50% of the outstanding U.S. dollar-denominated covered bond market. These institutions have the advantage of already being registered with the SEC, which makes following RBC's lead a natural choice.
Yet pending Canadian covered bond legislation that will limit collateral to non-government-guaranteed mortgages is sure to slow the pipeline even for these issuers.
On the European side, issuers still grapple with the stigma of the ongoing sovereign debt crisis in the region, which could make placing covered bonds with a U.S. investor base less of a bargain.
Although the U.S. still lacks a statute that would permit U.S. depository institutions to issue covered bonds, foreign banks have found that U.S. investors are interested in covered bonds. Foreign banks have met investor demand by issuing covered bonds into the U.S. relying on their domestic covered bond frameworks. The cover pools supporting these foreign-issued covered bonds are made up exclusively of assets located outside the U.S.
Foreign issuers of covered bonds have traditionally accessed the U.S. investor base through the 144A market, which exempts debt securities offered to U.S. investors from public registration. U.S. dollar-denominated covered bond issuance via the 144A market reached $100 billion at the end of May 2012, or just 10% of the euro-denominated outstanding benchmark market and 3.5% of the total covered bond market, according to figures reported by BofA Merrill.
However, this buyer base is restricted to qualified institutional investors that often have allocation restrictions that limit covered bond purchases to 15% of their holdings.
Jerry Marlatt, a securitization partner at Morrison & Foerster who was on the team that advised RBC on its SEC registration filing, said that the book of investors that bought into RBC's registered covered bond was about three times the size of the investor book on the bank's past private 144A offerings.
"It brought a lot of new investors into the covered bond space," he added. "You can expect to see the investor base grow as people who had never looked at covered bonds now have the opportunity to purchase this product."
Accessing this broader investor base via SEC shelf registration also broadens the marketability of the product by making the bonds eligible for the corporate bond transparency system known as Transaction Reporting And Compliance Engine (TRACE) as well as for inclusion in the bond indices, such as the Barclays Aggregate Bond Index.
"SEC-registered covered bonds are eligible to be included in broad bond indices, qualifying them for more internal investment policies," said Ben Colice, head of covered bonds at RBC Capital Markets. "Registered bonds’ eligibility for the TRACE system brings more transparency on pricing and better trading liquidity.”
Before SEC registration, the U.S. investor base consisted primarily of a select group of institutions or broker dealers that were comfortable with the covered bonds market.
Now with the registration, said Darren Getek, vice president in portfolio trading at Conning Asset Management, "you are forcing the hand of several other investors in the market to actually come in and learn the sector because they do need to have exposure to those bonds in order to match their investment benchmarks or to be a part of that particular market."
The lack of transparency has remained a persistent concern for U.S. investors. Karlo Fuchs, analytical manager for Standard & Poor's covered bond ratings, explained that most U.S. investors approach the analysis of covered bonds with a strong credit view; that is, they want to employ the same tools used when analyzing ABS. However, covered bonds issued under 144A have not always provided the level of disclosure that U.S. investors are used to.
SEC registration provides some measure of this transparency. MoFo’s Marlatt explained that disclosure requirements for the registered bonds are consistent with Regulation AB and are similar to the disclosure seen for credit card ABS or U.K. RMBS trusts.
“We believe this development will be viewed positively by the fixed-income market. Many investors have a strong preference to purchase registered securities,” Colice said.
Reg AB Means More Disclosure
Reg AB governs disclosure and reporting requirements for SEC-registered securitization transactions. The regulation was initially adopted in December 2004. On April 7, 2010, the SEC proposed substantial revisions to Reg AB. These revisions would, among other things, revise the shelf offering process for ABS and require ABS issuers to provide prospective investors with significantly more time to make investment decisions than under the current rules.
The April 2010 Reg AB II proposal also revises the eligibility criteria that must be satisfied for an issuer to use a shelf registration statement to eliminate the use of credit ratings.
In addition, the proposal includes a substantial overhaul of the current ABS disclosure requirements with regard to both cash flows and asset pool composition, including detailed disclosure, for most deals, of asset characteristics on an asset-by-asset basis.
The reconfiguration of the regulation would also revise rule 144A to require for structured finance products the provision of information to investors similar to the information to be required on a shelf registration statement form. It is not clear when the SEC is going to adopt the final Reg AB II rules, especially in light of subsequent congressional mandates prescribed under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the upcoming November elections.
Riz Sheikh, head of covered bond structuring in the Americas at Barclays, said that the RBC-registered covered bond, although it is not viewed as a securitization transaction, must apply similar Reg AB disclosure standards to its covered pool at the guarantor level.
"What you might find, over time, is that the standard in general will migrate toward more disclosure," he explained. "It could create a situation where similar disclosures are required regardless of how you access the U.S. covered bond investor base."
The RBC Model
Marlatt said that RBC used a contractual structure to issue covered bonds, with a separate entity that holds the cover pool and acts as the guarantor. In other words, although the guarantor is owned 99.9% by the bank, a "sliver of interest" is owned by an SPV, so that if RBC went away there would still be a living partner available to maintain the existence of the guarantor.
"From the SEC’s perspective, it meant two securities were being issued — one by the bank and the other is the guarantee provided by the guarantor," Marlatt said. "Both securities have to be registered, and you want both on the shelf registration statement because you wouldn't want to have to file a registration statement for the guarantor every time you did a covered bond."
On May18, the SEC filed a "no action letter" that outlined the conditions of including the guarantor as a co-registrant on the registration statement. The SEC said in the letter that "the covered bonds are not deemed to be ABS; however, disclosure that is consistent with Reg AB is required." And as Marlatt mentioned, the disclosure regarding the cover pool assets is similar to the disclosure for a credit card or U.K. RMBS master trust. This issue of disclosure is an important one when measuring the potential for more registered covered bonds to be placed in the U.S. market, because issuing in the registered form means that the bank is subjecting itself to continual reporting to the SEC, which many foreign banks may not be ready for, Marlatt added.
For a bank that has never issued securities in the U.S., the country’s reporting obligations can be seen as burdensome. "A bank that is not SEC registered is unlikely to go through the process just for covered bonds," said Anne Caris, a covered bond analyst at BofA Merrill.
Already SEC-Registered Banks
According to Barclays’ Sheikh, the universe of foreign banks already registered for senior unsecured deals is limited to only a dozen or so entities.
"These are the likely issuers, the ones who already report under the SEC requirements and therefore, with some additional disclosure on the asset side, could more readily contemplate registered covered bonds," he said. "When you think of it that way you realize that, apart from perhaps the Canadian banks, this is not an immediate game changer."
Foreign banks already registered with the SEC that have covered bond programs as of December 31, 2011, include the Royal Bank of Scotland, Barclays, Santander UK,Credit Suisse,Deutsche Bank, Allied Irish Bank, Banco Santander, AEGON N.V.,Royal Bank of Canada,Toronto Dominion Bank, Bank of Montreal,Bank of Nova Scotia, Canadian Imperial Bank Of Commerce (CIBC) and Westpac Banking Corp.
Canadian Banks Next in Line
As of Sept. 13, a DBRS report released the same month estimated that there has been $66 billion issued in covered bonds, and there is the potential for the largest six Canadian banks, in aggregate, to issue another $57 billion in the sector.
That being said, an ongoing overhaul of Canada's covered bond market has created uncertainty for Canadian issuers. Aside from RBC’s $2.5 billion offering, new issuance of covered bonds by Canadian banks, in any currency, has come to a standstill since the end of the second quarter, following a very active first half of the year, according to DBRS.
This is a result of new covered bond legislation that has been put forward, but not yet enacted, that prohibits the inclusion of mortgages insured by Canada's national housing agency, Canada Mortgage & Housing Corp. (CMHC), in covered bond pools.
RBC, S&P’s Fuchs said, benefits from the fact that it’s actually the only Canadian bank that has only non-insured collateral to include in covered pools.
"This covered bond legislation will actually significantly impact further Canadian supply in the next year, reflecting the fact that in the past, most of the mortgage origination has happened with this government guarantee," he said. "First they will need to ramp up the stock of eligible collateral."
DBRS said in its report that the larger Canadian banks such as Bank of Nova Scotia and CIBC are likely to ramp up their portfolios with uninsured mortgages with a maximum loan-to-value ratio of 80%.
"Some of the potential challenges for buyers of future covered bonds under the legislation will be to understand the dynamics of the residential mortgage market in Canada, including macroeconomic conditions, unemployment trends, consumer indebtedness and bankruptcy laws," DBRS analysts said in the report.
Sheikh said that foreign covered bond issuers are largely motivated by the pricing benefit they get by accessing a more diversified investor base, but also by what the rest of the market is doing.
In the Canadian context, he believes that other banks will be looking at issuing a registered or 3(a)(2)-exempt covered bond as a way to recover some of the price increase associated with having non-guaranteed loans in the covered pool.
No issuance has yet been done under 3(a)(2) of the Securities Act of 1933. To issue under section 3(a)(2), an issuing bank must have a U.S. branch or agency, and the branch or agency must guarantee or issue the bonds. MoFo’s Marlatt said that there are also several considerations with an offering under Section 3(a)(2), which range from capital implications for the branch or agency to required discussions with the U.S. banking regulator. Repatriation of offering proceeds may be limited, and sales would likely be limited to “accredited investors.” More investors will come later.
However, Sheikh does not expect SEC registration to immediately open the door to U.S. retail investors. For now, he said, SEC-registered covered bonds will continue to be placed with the same group of institutional investors, although these institutions will be able to put more money to work than they can in covered bonds issued via the 144A market.
"The key benefit of SEC registration is that the securities are TRACE and Index eligible,” he said. “So while issuers aren't going to access the retail investor base just yet, SEC registration materially increases the investment buckets available at existing asset managers and investors."
Not only does SEC registration help investors ramp up covered bond purchases by lifting limit restrictions for traditional 144A securities, but it has also ramped up activity because these investors are looking to get some value out before the market gets overcrowded.
"Once other investors got wind that there would be registered deals in the market, we saw activity ramp up in quite strong spurts," said Conning Asset’s Getek. "On the Canadian side, as investors became familiar with the product and they looked at the contractual structure and pending legislation, we saw an increase in trading flows as they dabbled in some of the issues.”
Although it was not the consistent volume the market was seeing with some of the larger fixed-income sectors, Getek said that there was a pickup in activity that can be attributed to the expanding investor base. “There were more people that were actually taking the sector seriously and looking at what sort of value could be captured before a larger group of investors stepped in," he added.
Other Jurisdictions Do the Math
Getek believes that the success of RBC’s deal will likely get other banks to take a closer look at doing deals in the U.S. As long as the cross-currency swaps valuation, which allows for the transfer of assets or liabilities from one currency into another, works, along with the potential premium these issuers have to pay for issuing outside of their domestic markets, then "the market will probably see more deals that are likely to come in a significant wave," he said.
"RBC was the first one to break the ice, and because of that you may see another deal or two come to market, and from there you will see the floodgates opening," Getek added. "European issuers are getting into the U.S. marketplace to diversify their investor base and their funding needs, and you see [144A] deals come to market anywhere from two to four times oversubscribed. Given the strong demand and the amount of cash on the sideline and the success of recent issues, you may actually see more deals ramp up to come to market."
European issuers still find accessing the investor base via the 144A market attractive. For example, in September, Sweden's Stadshypotek issued a 144A U.S.-dollar, seven-year covered bond due October 2019 at mid-swaps plus 72. The $1.5 billion offering was led by BofA Merrill, Barclays, Deutsche Bank and Morgan Stanley; it attracted $2.75 billion of demand.
What is most interesting about the deal is that it extended the curve to seven years, whereas all other deals that have been placed in the 144A market where either three-year or five-year transactions, according to figures reported by BofA Merrill. "That shows you that the market is developing and U.S. investors are becoming more comfortable with the covered bonds product," even without SEC registration, Barclays’ Sheikh said.
Also in October, Nord LB brought the first German covered bond to the U.S. market since 2006. The $1 billion, three-year deal priced at 50 basis points over mid-swaps (this rate is often used as a reference to calculate the premium paid by the buyer of a bond).
The offering was led by BofA Merrill, BNP Paribas, Barclays, Credit Suisse and HSBC. S&P also reported in October that BayernLB was looking to launch a $500 million, two-year mortgage Pfandbrief at mid-swaps plus 30 basis points.
"Today we have just priced the first German Pfandbrief deal and, despite the absence of the Canadians from the market due to pending legislation, the market has continued expanding, with $37 billion of issuance so far in 2012," Sheikh said.
MoFo’s Marlatt said that the growing appetite among foreign banks to come to the U.S. is because they are looking to diversify.
"The market in Europe is very big, but the U.S. offers a new investor base that is attractive, and by widening the base it should benefit pricing," he said. "Issuers recognize that the U.S. is the largest market in the world, and with the GSEs in receivership they aren't issuing bonds the way they used to."
Accordingly, as the Fannie Mae and Freddie Mac bonds held in portfolios mature and run off, there is a growing investor base of people who used to buy those bonds needing to put money to work, so covered bonds are one way to get exposure to the mortgage assets.
"We are starting to see traditional MBS investors looking for alternatives, and these investors are contemplating the covered bond product," said Alexander Stepanoff-Dargery, vice president of financial institutions group debt capital markets origination for Natixis in New York.
Investors Get a Europe Scaled Back
European issuers historically make up a significant portion of U.S. covered bond issuance. According to Natixis, issuance so far this year is at roughly $36.3 billion of syndicated covered bond deals, and one-third of that supply has come from European issuers.
However, U.S. investor demand is expected to increase. That is because there are fewer foreign investment-grade credits available since the start of the eurozone sovereign debt crisis in late 2009. Stepanoff-Dargery said that total senior foreign investment-grade issuance done year-to-date is roughly 22% and 18% lower than 2011 and 2010, respectively. The drop in investment opportunities has driven some traditional buyers of corporate debt to consider foreign covered bond investments.
Europe’s sovereign debt crisis has dampened issuance of European covered bonds, which represented roughly 40% of U.S. dollar-denominated issuance in 2011 and about 50% in 2010, according to Stepanoff-Dargery.
But in the U.S., investors are focused on the issuer names, the structure and the collateral, which have caused U.S. investors to buy these bonds at a slower pace than European investors. BofA Merrill’s Caris said that U.S. investors are more selective and today are more worried about the eurozone crisis, so only the strongest issuers in Europe have been able to access the U.S. market. As a result, European issuance in the country has slowed because U.S. investors are getting pickier and more wary of European credits.
"Typically it's been the Nordic banks; Swedish banks are also strong but have more liquidity in their home markets and less of a need to tap a foreign investor base," she noted. "U.S. investors are focusing on the collateral, what you would get back in case of bankruptcy. They don't just buy the product because it's a covered bond; they buy the product because they believe in the quality of the collateral and in the issuer and the framework."
One calculation European issuers must make when deciding whether to issue in the U.S. market is the expense of cross-border, cross-currency transactions or the expense of swapping proceeds back into euros. Foreign banks that come to the U.S. and issue in U.S. dollars need swaps in deals to take their domestic assets and create U.S. dollar collections, Marlatt noted. They must also swap what proceeds they take away from the market back into their domestic currency.
"In the covered bond space, just like with other funding instruments including ABS, refinancing in non-domestic currencies is mostly a matter of investor diversification and cross-currency basis arbitrage," said Fritz Englehard, a London-based covered bond analyst at Barclays. "Particularly in the case of some German and French banks, there is a third element at play. These banks also originate (mostly in public sector, project, ship and aircraft finance space) assets in non-domestic currency, and with funding in non-domestic currency they seek currency-matched financing, which is usually cheaper compared to entering into hedge transactions."
Rating agencies are impartial as to which currency the issuer of a covered bond chooses, as all covered bonds are ranked pari passu. Thus, what rating analysts look for is if the overcollateralization available in the covered pool adequately supports all the outstanding bonds.
According to Fuchs, S&P's covered bond ratings are linked to the issuer, and if the issuer has any challenges coming from the sovereign — for instance, Spanish issuers are impacted by Spain's downgrade — a downgrade of the sovereign usually typically prompts a revision of what S&P calls the Bank Industry Country Risk Analysis, or BICRA, which establishes the anchor rating for all of a country’s banks. So the starting point of the covered bond rating might be lowered.
This is not the only worry, Fuchs said. What might also happen is that an issuer might structure a swap arrangement in the covered pool, which has a certain rating framework with which the issuer would need to comply to support the rating.
"The provider of the swap might be banks from the same country that might also be impacted and may have challenges to replace themselves," he said.
Also, there is the problem of a cap when it comes to rating above the sovereign. In Europe, the maximum rating of a mortgage covered bond is typically six notches above the sovereign ratings.
"All this means is that the covered bond is always exposed to many risks, and it's something that investors do not like for a product that is very highly rated which could in a month's time become downgraded," Fuchs said.