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Friday, 15 December 2017

Hitting the ground running

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The Australian covered bond market has come a long way in a short space of time. Although the possibility has been discussed for years, its first issuance did not come until late last year. Yet from a standing start, Australia has established itself as a covered bond market to be reckoned with.

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It is now easy to forget that until October last year, Australia did not have a covered bond market. Progress had been hampered for years by regulatory concerns, the main one being the impact it would have on the existing senior unsecured market: any claims made on banks by investors in the senior unsecured market are subordinated to covered bond claims in the event of a default.

The Australian Prudential Regulatory Authority also worried about the impact on depositors, with any depositor guarantee scheme sitting awkwardly alongside a thriving covered bond market. 

Eventually, however, the need for a covered bond market became irresistible. “APRA had to move because Australian banks had a limited choice when it comes to assets that count as liquid assets under Basel III,” said Mauricio Noe, head of senior and covered bonds, EMEA at Deutsche Bank. “The Australian government doesn’t issue because they run a surplus, so they needed to give the banks something to invest in.” 

The regulator’s concerns about structural subordination are valid, said Derry Hubbard, head of covered bond origination at BNP Paribas, though ultimately they were neatly resolved in much the same way some other jurisdictions have tackled the issue, via an issuance cap, which for Australia stands at 8% of issuance. 

Suncorp joins the party

So far issuance has been dominated by the so-called “big four” Australian banks, though more recently Suncorp, in the second tier of antipodean lenders, has also joined in the party. In the Australian covered bond market’s short life, there have been obstacles, including a few significant disappointments that threatened to undermine the appeal of this emerging asset class. The euro crisis has proved a difficult backdrop against which to launch successful deals, especially given the inherently European nature of the covered bond sector. 

“The Australian government doesn’t issue because they run a surplus, so they needed to give the banks something to invest in” 

In October, when the big four banks started launching their transactions, the US dollar market seemed the way to go: “The euro market was experiencing acute volatility at the time relating to the sovereign debt crisis, while dollar pricing looked favourable,” said Sean Henderson, head of DCM at HSBC in Australia.

The logic seemed sound enough at the time but in retrospect it was the wrong call. “The US investor base isn’t as broad or deep as Europe in the product and so the deals were not without their challenges in execution,” said Henderson. 

“Some read too much into the outcome of those trades,” he said. The banks are sophisticated enough to know one or two tougher trades do not undermine the relevance of the product, and subsequent issuance has demonstrated this point, he added. 

Given the fact that it is a young market, it remains to be seen whether the regulator and the public will reach the same conclusion.

Antipodean appeal

Although the quality of the issuer and the cover pool of a specific transaction are important factors in determining the outcome of a covered bond transaction, the principal consideration is the perception of the country from which the issuance is made, said Heiko Langer, head of covered bond research at BNP Paribas.

And Australia looks pretty appealing from an economic perspective right now, especially from the vantage point of an overwhelmingly European investor base. There is a strong link between a covered bond and a sovereign bond from the same country, and in the absence of Australian sovereign paper, covered bonds have become a good way of taking on Australian sovereign risk for international investors.

Yet the Australian covered bond market is driven principally by domestic investors. Australian banks have issued around A$30bn, with about 40% of this denominated in Australian dollars. Those that assumed the Australian covered bond market would be dominated by offshore accounts have been surprised, with domestic investors showing considerable enthusiasm.  

Commonwealth Bank of Australia opened the Aussie dollar market and wanted to prove depth was possible from the outset, paying up a bit to do so.

“They may have put a small premium on that trade, but also proved there was A$4bn of demand and 90 potential investors out there, and at the same time borrowed well inside their offshore funding costs,” said Henderson. In the end 20% of the CBA deal went offshore, with the deal redefining what the Aussie dollar market could be, paving the way for Westpac to follow, and ultimately Suncorp too. 

This added to a strong list of markets available for Australian issuers to tap. The US dollar market still arguably offers the best pricing, but performance throughout the sovereign debt crisis has confirmed that the euro market offers the most efficient execution. For Australian issuers the Aussie dollar offers size, while there are plenty of other markets that can be tapped opportunistically.

These options are great news for issuers that have to contend with the decline of the securitisation market. The repricing of bank risk, in terms of what can be achieved in the secured market relative to the unsecured market, has also reinforced the appeal of the covered bond market for issuers, meaning additional potential cost savings, said Langer. An overhang of government guaranteed Australian bank debt that is coming due is being partially refinanced in the covered bond market, he said. 

Riding without stabilisers

So there has been a confluence of factors contributing to the dramatic growth of the covered bond market in Australia. What is notable is that this growth has been achieved without the same regulatory support that is found in many regions: Australian banks cannot use covered bonds in their Basel III liquidity buffers, as some of their peers in other parts of the world will.

There is, however, a growing expectation that other Asian regulators will allow covered bonds to be counted as liquid assets in calculating the liquidity coverage ratio. Australian banks likely to benefit from increased demand from these countries if this proves to be the case. 

The omens are good that demand will be considerable and consistent. Investors in Australian covered bonds often ask about the state of the real estate sector in that country, as well as other factors, such as Chinese slow-down and commodity weakness, said Hubbard. Such concerns might have proved to be dissuasive. But investors are quickly satisfied that the covered bonds offer a high degree of safety due to the quality and indexed nature of the pools, said Hubbard. 

Rare opportunity

Crucially, covered bonds represent an increasingly rare opportunity for a Triple A investment, at a time of numerous sovereign downgrades. There is a robust safe haven bid, said Hubbard, with investors flocking to Australian covered bonds to diversify away from European exposure, with confidence high that the asset class will offer capital protection and stability. 

“The forthcoming emergence of the New Zealand market will also boost issuance in the sector”

The Australian market therefore has considerable scope to grow from here, said Hubbard. All the big banks now have established covered bond programmes which are likely to be actively used. How much depends on the specifics of the market, for example the price that can be achieved versus unsecured debt and the evolution of the mortgage market in Australia. “The forthcoming emergence of the New Zealand market will also boost issuance in the sector,” said Hubbard. 

Australian issuance is determined more by market and price stability than investor availability: Australian institutional investors are long cash, and there is not enough FIG issuance in the country to satisfy investor demand for Triple A paper.  

Issuance spike

The potential size of the Australian covered bond market, assuming an 8% cap on encumbrance, is about A$100bn–$120bn, but banks will not want to get into a situation where all the refinancing will be due at once, said Henderson.

So issuance is likely to come in at around A$20bn–$25bn per year, or maybe A$5bn–$7bn per bank. Issuance could spike in times of market stress as covered bonds are more effective instrument when funding in times of volatility, though not to the point banks will come close to that 8% barrier, said Henderson. 

Covered bonds have been well received by the market and they are a very good weapon to have in the armoury, offering access to a part of the European market which remains open even when other parts are closed. 

There are limits to growth potential, however. There are few institutions in Australia with a sufficient mortgage book to consider launching covered bond transactions, with smaller lenders likely to favour the simplicity of an RMBS transaction.

Meanwhile, Aussie issuers also have shrinking funding requirements: a few years ago banks were raising A$35bn–$45bn a year, but that has now shrunk to around A$20bn, with banks using their deposit bases more aggressively than in the past. But this merely suggests investors will be all the more keen to buy up whatever is available. 

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