The introduction of a legal framework for covered bonds in Canada has undoubtedly broadened the appeal of these securities, which are backed by both the credit of the bank issuing them and a pool of mortgages on the bank’s balance sheet. 

Already ultra-safe, in the sense that they have a dual guarantee, Canadian covered bonds now benefit from increased disclosure about the mortgages behind them and more certainty about recourse to the cover pool in the event of a default.

But so far, this broader appeal hasn’t resulted in increased issuance. For one thing, the covered bond issuance limit of 4% of total assets, which was put in place in June 2007 by the Office of the Superintendent of Financial Institutions, Canada’s bank regulator, is unchanged.  Add into the mix a new restriction that prohibits banks from using insured mortgages as collateral, and what you get is a market that has been slow to restart.

So far, only four of the seven banks that issued covered bonds before the legal framework was adopted in 2012 have registered new programs with the Canada Mortgage and Housing Corp. (CMHC).
DBRS calculates that in the first 11 months of 2013, just $11.8 billion (Canadian dollar equivalent) of Canadian covered bonds was issued; this is a decline of $3.8 billion year-over-year. 

Investors have been looking to Canada and other markets to help offset a drop in issuance of covered bond by European banks. Legal frameworks are also being introduced in South Korea, Panama, Mexico, Morocco, New Zealand, Singapore and possibly the United States. But Canada’s experience suggests that there may be limits to the expansion of this market.

Covered bonds have existed in Europe since 1769. Denmark is the biggest issuer of mortgage-backed covered bonds; Germany and France are also large issuers.  But a combination of deleveraging by European banks , improved access to unsecured funding and a desire to preserve assets for cheap funding from the European Central Bank have all made issuing covered bond less attractive for the region’s financial institutions. The Royal Bank of Scotland expects that issuance of long-term, euro-denominated covered bonds this year will fall short of the amount being redeemed by €36 billion ($48.7 billion).

By comparison, outstandings fell by €69 billion in 2013.

At the same time, demand for covered bonds, particularly from bank Treasuries, has been growing, resulting in ever tighter spreads for issuers. Much of the appeal is regulatory in nature: covered bonds will be exempt from European rules requiring bondholders to help absorb bank losses. They may also be classified as Level 1 assets under Basel III’s Liquidity Coverage Ratio.

Canada’s market is comparatively young: it dates back just seven years, to 2007. But in that short period, covered bonds have become an important source of funding for large Canadian banks.
According to figures reported by Bank of America Merrill Lynch (BofAML), there is C$63 billion ($56.9 billion) in covered bonds outstanding. (This number does not incorporate deals issued in the past six months under the new legal framework.) Issuers have been major contributors to the growth of the U.S. dollar- denominated covered bond market since 2010. According to DBRS, of the seven banks with legacy programs, all issued in U.S. dollars and four issued exclusively in the denomination.

So even before the legal framework was introduced, there was a ready market for Canadian covered bonds denominated in either dollars or euros. To date, however, only the Canadian Imperial Bank of Commerce (CIBC), the National Bank of Canada and the Royal Bank of Canada (RBC) have registered covered bond programs with the CMHC and issued covered bonds under the new legislation.

Two others, Caisse Centrale Desjardins du Quebec (January 2014) and Bank of Nova Scotia (July 2013) have registered programs with the CMHC but have yet to bring a deal to market; and two more that were regular issuers in the past, Toronto-Dominion Bank and Bank of Montreal, have yet to register new covered bond programs.

“We were hoping everyone would have been on board six to nine months ago and issuing strongly into all markets, both in the U.S. and Europe,” said Riz Sheikh, Barclays’ head of covered bond structuring, Americas.
Sheikh said that one reason it has taken Canadian banks longer than anticipated to bring deals to market is that the registration process has been a lengthy one. “The CMHC is taking it all very seriously and reviewing programs in detail, making sure they work from an investor perspective, including compliance with disclosure requirements,” he said.

From an investor perspective, the legislative framework is good because the regulator is taking an active role and making sure that high standards are being applied to issuance from Canadian banks. Issuers disclose detailed cover pool data, comply with a comprehensive set of tests to protect against credit risks and employ an independent asset monitor to oversee compliance with collateral requirements.

However, Canadian bonds, according to Ben Colice, head of covered bond origination at RBC Capital Markets, have always enjoyed very large receptivity across a wide range of global markets because they are largely viewed as a stable, low credit-risk product.

And the legal framework hasn’t produced a ratings uplift. DBRS rates the new legislative covered bond market as “strong” — just as it did on Canada’s legacy structured covered bond market — as the history of the Canadian covered bond market is relatively short and investor support for domestic issuance is still limited. The ratings agency said that for it to consider a covered bond legal framework as “very strong,” it would expect the market environment and systemic support to be robust.

Anne Caris, research analysts at BofAML, explained that for the new programs, “the recovery analysis performed by rating agencies confirmed the overall sound quality of Canadian uninsured residential mortgage pools.”

She said that, “while the expected losses are well above the ones estimated for CIBC’s ‘structured’ [legacy] covered bond program for example, they remain moderate and compare well with peers – especially Australian, French (home loan programs), Norwegian, Swedish and Swiss issuers.”

And this arguably incremental increase in safety comes at a big expense, at least for issuers, which are saddled with prohibitive costs and time constraints.

However, Jean-Sébastien Gagné, director of securitization at the National Bank of Canada, said that the biggest change wrought by the legislation is that it prohibits the use of CMHC insured loans into the covered pool. “In fact, following the new legislation, even before the establishment of National Bank of Canada’s new legislative program, the bank couldn’t even use our legacy structured program since it was composed of CMHC-insured loans,” said Gagné. “It’s really the intent of the law that issuers use only legislative programs without any insured loans.” 

Other say limiting collateral for covered bonds to uninsured mortgages will not have such a big impact on covered bond volumes. That’s because Canada’s big banks have enough uninsured mortgages on their balance sheets to sustain issuance going forward.  A bigger limitation, and one that has been in place since 2007, is that Canadian banks can use no more than 4% of assets as collateral — the strictest such limit across covered bond markets.

Nevertheless, Sheikh at Barclays expects that over the coming two to three months the remaining issuers will start coming online.

The slow restart in Canada’s covered bond market has had a big impact on overall issuance of dollar denominated covered bonds. Since 2010, an average of $35 billion covered bonds was issued in the United States each year, according to figures reported by the Royal Bank of Scotland. Of this amount, Canadian issuers have consistently accounted for 40% to 50% of issuance.

But in 2013 just $22 billion was issued, just half of the $44 billion issued in 2012. “It’s a noticeable decrease that is largely explained by Canadian issuers not coming to market as expected and the change in the US /European swap basis,” said Sheikh, commenting on the decline in dollar denominated issuance.
Even if Canadian issuers had come back to the market sooner, however, it’s unlikely that U.S. volumes would have been much higher last year.  That is because foreign covered bond issuers have been very sensitive to the U.S./European swap basis.  “It hasn’t been as advantageous to come to the dollar market as a result,” said Sheikh.

National Bank of Canada, the latest Canadian bank to have set up a legislative covered bond program, issued its inaugural deal denominated in euros in December. The five-year covered bond was sized at €1 billion. Gagné said that his firm was very happy with the levels achieved compared with where the bond would have priced had it been structured as a dollar issuance because of the relative value in the five-year part of the curve.

“We are primarily happy with the fact it is an inaugural issuance that opened a new market for us and attracted a wide investor base,” he said. “It ensures us diversification of funding sources by maintaining access to global funding markets.”

It’s the first deal that National Bank of Canada has done in the European market. The bank only issued U.S. dollar denominations from its structured covered bond legacy program composed of CMHC insured loans.
Although the legacy program didn’t prohibit euro-denominated issuance — it was a global covered bonds program that allowed issuance in several denominations— in past years the levels in Europe were not attractive.

Gagné explained: “Not only because of the spread of the bond by itself but also because of the currency basis that transfer back the funds into Canadian dollars, issuing in Europe was not as interesting as issuing in the U.S.”

Now that the basis has come back to historical attractive levels, “Canadian banks can issue in euros and legislation means access to a broader euro investor base,” he said.

Gagné said that following investor meetings held in December last year, the bank decided to launch its inaugural legislative covered bonds in euros,  because “European investors showed great interest for the Canadian credit as well as our name.”

Another attraction for European investors is the fact that the introduction of a legal framework for Canadian covered bonds makes these securities eligible to be placed with the European Central Bank for collateralized funding.

But Gagné said that the U.S. investor base will continue to be important for the National Bank of Canada. “With all of the work that we’ve put to establish the program we want to make sure its successful and that we are a regular issuer” he said.  “But on a relative value perspective we are still going to look at all options and depending on the levels and market condition we will decide on when to enter the U.S. market.”

RBC has issued both in euros and U.S. dollars, from its legislative program and its legacy program.
According to DBRS figures, the bank currently has $20.47 billion in covered bonds outstanding. RBC had the advantage of having a cover pool that was already comprised of uninsured mortgages. The bank simply made a few amendments to its program. Key modifications for RBC have been related, notably to the 10% substitute asset limit, the responsibilities of the cover asset monitor, and six-month maximum cash holding.

“RBC had to do slightly less retooling of its program than some of the other banks, and that retooling has obviously impacted other banks’ ability to issue,” said Colice.

RBC also has the distinction of having issued the only covered bond to be registered with the U.S. Securities and Exchange Commission, in September 2012. It launched a US$1.75 billion deal that was oversubscribed and placed with a diverse investor base. According to BofAML, 53% of the bonds were purchased by U.S. investors, 20% of the bonds were placed in Europe, 20% were placed with domestic investors and 7% were placed with Asian investors. The bonds were offered at a spread of 35 basis points over mid-swaps.
RBC subsequently issued a €2 billion, seven-year benchmark deal. The deal was also well oversubscribed (1.8x) and was issued at a premium versus the secondary market at 16 basis points over mid-swaps.

Caris said that in the U.S. dollar market, RBC’s “registered” covered bonds “offer an attractive spread pick up versus Canadian ‘non registered’ covered bonds for limited downside risks, especially in the short and long end of the curve. They are also good value compared to their European counterparts.”

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.  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.

SEC registration brings a lot of new investors into the covered bond space. 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 the Transaction Reporting And Compliance Engine (TRACE) as well as for inclusion in bond indices, such as the Barclays Aggregate Bond Index.

Colice believes that in the near term, other Canadian banks will also look to have programs SEC registered as they complete requirements for establishing a legislative covered bonds program. “This is another fact that will, over time, drive issuance choices between U.S. dollars, euros, etc,” he said.

Smaller Canadian mortgage originators have not historically played a large role in Canadian covered bonds issuance. These banks have tended to rely more on securitization programs, mainly the CMHCs  National Housing Act Mortgage-Backed Securities (NHA-MBS), which was established in 1986, explained Kevin Chiang, senior vice president, Canadian structured finance at DBRS.  Another funding alternative for these lenders is CMHC’s Canada Mortgage Bonds  (CMB) established in 2001.

In its 2013 budget, the Canadian government announced that it would prohibit the use of insured mortgages as collateral in non- CMHC-sponsored securitization programs. Mortgage originators can still go to the NHA-MBS and CMB but the CMHC has placed a cap on the new issuance limit for 2014, said Chiang. According to CHMC, that cap is  $80 billion for new guarantees of market NHA MBS and up to $40 billion of new guarantees for CMB.

DBRS notes that currently around $6 billion of insured mortgages are funded in private- sector asset-backed commercial paper (ABCP) conduits, a small but nonetheless “important liquidity management tool.”  DBRS is concerned that the lack of flexibility in using ABCP to fund insured mortgages that are generally not economically suitable for NHA-MBS or CMB issuance means these mortgage originators may not be able to offer the same range of mortgage products as Canada’s big banks. 

“If the mortgage originators want or are forced to reduce exposure to the mortgage default insurance, they’ll have to look for alternative funding methods,” said Chiang.

A covered bonds funding alternative is likely to prove too costly. The Canadian legislation registration fee of $700,000 alone is enough to deter smaller banks from setting up a program.  But the biggest problem these issuers face is also the 4% issuance limit, said Chiang.  It makes the costs of setting up a program too expensive. Small banks simply have a smaller asset base over which to spread the cost.

“One of the critical constraints they have is to find new ways and they can’t afford covered bonds, or they can’t do deposit taking – for them they are in a tight spot right now,” said Chiang.

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