Shifting the goalposts
Canadian covered bonds will undergo the most dramatic upheaval in their five-year history before the end of this year, when a new legislative framework for the instruments will fundamentally change their credit characteristics.
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Canada’s new law on covered bonds is included in the 400-page Budget Implementation Bill (Bill C-38) that is working its way through Canada’s parliament amid considerable controversy. Nevertheless, the covered bond legislation in the bill is expected to pass into law before the end of the third quarter, and its key provision will prevent issuers in future from including insured loans – whether the cover comes from the public Canada Mortgage and Housing Corporation or private insurers, such as Genworth MI Canada – in cover pools.
Given that 85% of the C$63bn of outstanding Canadian covered bonds are backed by insured mortgages, this will clearly be a game changer for both issuers and investors. Government insurance currently covers 100% of CMHC-backed loans and 90% of those covered by private insurers and so minimises the credit risk that investors take on the bonds.
This comprehensive insurance has led many investors to view Canadian covered bonds as quasi-sovereign risk (although most traders do not wholly go along with this analysis), which offers a premium of 50bp–60bp over sovereign debt of comparable maturity (generally three to five years).
“In effect, you’ve had sovereign risk, as the collateral was insured by the Canadian state,” maintained Tim Skeet, managing director in the financial institutions group at Royal Bank of Scotland in London.
While the removal of insured mortgages from covered bond collateral pools – along with increased regulatory oversight of the CMHC – is deliberate government policy to prevent an excess of cheap home loan funding from causing a bubble in the Canadian housing market, the move will force all the country’s banks apart from Royal Bank of Canada (which already issues bonds backed by uninsured mortgages under its global contractual framework) to make significant adjustments to their covered bond programmes. (See “Crumbling foundation”.)
“They will all become much more credit-driven products than a rates-driven product.” said Skeet. “The banks will still be able to issue, but what we don’t know is how the market will respond to this change in their underlying characteristics.”
One inevitable change if banks want to preserve the Triple A credit ratings that all Canadian covered bonds currently enjoy will be a significant increase in the overcollateralisation of cover pools. Although the new law does not specify minimum levels of overcollateralisation, the ratings agencies will certainly demand more protection on this score to compensate for the heightened credit risk.
Most issuers will probably have to boost the overcollateralisation in their pools by 100% or more from the present average level of just over 5% – bearing in mind that the highly rated RBC currently has to maintain approximately 9% overcollateralisation in its cover pool to keep the top investment-grade rating for its programme.
Vanessa Purwin, senior analyst at Fitch Ratings in Toronto, confirmed that overcollateralisation levels necessary to support Triple A ratings on any registered covered bonds issued under the new legislation were likely to be comparable to that in the RBC pool.
“To achieve Triple A ratings, overcollateralisation levels need to be consistent with loss expectations under a Triple A stress scenario,” she said. “Overcollateralisation levels will ultimately depend on the credit attributes of the cover pool and the stressed market value of the assets in a liquidation scenario – as well as the historical default and loss performance of the issuer’s uninsured mortgages.”
Purwin added that she expected most issuers to maintain overcollateralisation levels that would support Triple A ratings on bonds that they issue under the new regime.
Demand for premium
Regardless of the ratings, however, investors are sure to demand a premium for the increased credit risk of the new registered bonds – particularly as the instruments will be competing in the secondary market against a large volume of outstanding bonds that will still be backed by insured mortgages – and in some cases will not mature for up to another four years.
This will create two-tier pricing in the market as long as old-style bonds remain extant. While the differential between individual issuers’ “old” and “new” bonds will no doubt vary from institution to institution, it is likely to be a significant consideration for all of them.
Francis Kestler, vice-president at Bank of Montreal Capital Markets in Chicago, pointed to the 15bp–20bp premium at which RBC’s April 2015 bond currently trades to CMHC-backed instruments as a guide. “I would think it [a new covered bond] would trade much closer to where the banks’ senior unsecured debt trades rather than 60bp tighter as at present.”
Not easy to predict
Andre Philippe-Hardy, an analyst with RBC Capital Markets in Toronto, suggested in a recent note to clients that Canadian issuers were likely to see an increase in origination costs of at least 10bp to 15bp.
What the impact will be on demand from the historical investor base for Canadian covered bonds – which has been dominated by the US 144a private-placement market – for a product that is now going to require a good deal more credit analysis than before is not easy to predict at this point.
Kestler said appetite would probably fall away in the near term as investors re-appraised the market. “I think a lot of people became comfortable with the underlying bank credit and the underlying collateral,” he said. “Now they are going to step back and look at the sector again to see how it’s going to work.”
If demand from the historical investor base does decline – if only in the short to medium term – one option for Canadian issuers to consider will be to follow the recent initiative that RBC has taken to register its covered bond programme with the US Securities & Exchange Commission.
This will enable the bank’s covered bonds to become a “mainstream” capital markets product in the US, unlike the 144a market placements that have accounted for all Canadian issues to American investors up to this point. The advantages of SEC registration include eligibility for inclusion in bond indices (such as the Barclays Aggregate Bond Index) and the ability to sell to retail investors – both of which will significantly widen the bank’s pool of potential buyers. “That will certainly broaden the universe of US investors for a Canadian issuer,” said Skeet.
Other advantages over 144a offerings are the absence of the restrictions on offerings and communications that govern the private-placement market, and no limit on the repatriation of proceeds.
RBC filed its registration statement in May, and – depending on how long the SEC takes to approve it – could be in a position to issue covered bonds publicly in the US before the end of the third quarter of the year.
“What that will do is add a little bit more liquidity to the market in general,” said Kestler at BMO. “I would expect other Canadian banks to follow RBC’s example, and I would hope that if they do come into the US public market they will be looking to issue at least twice a year.”
How many choose to do so remains to be seen. The registration process is time-consuming and not without cost (in terms of required disclosures as much as expense), and some institutions with weaker balance sheets than RBC may find it difficult to meet the requirements of the exercise.
“That’s a decision each bank will have to make based on its capital-raising needs,” observed David Lynn, a member of the legal team at Morrison Foerster that has been advising RBC on the SEC registration process.
The change in the market will certainly lead Canadian banks to review their funding options, and it may well be that covered bonds are no longer a universally attractive option as they are at present.