In early September, while top tier European issuers cautiously debated whether to launch an opportunistic benchmark, Toronto Dominion Bank came to market for the second time and launched the largest dollar covered bond in history. The triple-A rated borrower sold a $5bn dual tranche transaction that broke the record held by HBOS, which sold a $3bn 10 year trade in 2007.
"Clearly the US market is influenced by the problems in Europe, but covered bonds have been more insulated against recent volatility," says Peter Walker, assistant vice president, treasury and balance sheet management, Toronto Dominion Bank Group. "On top of this the strength of Canadian issuers and Canadian programmes have proved popular with investors."
It is appropriate that a Canadian issuer should have the distinction of selling the largest ever dollar trade, given that Canadian banks make up an ever-increasing proportion of that market.
The jurisdictions first transaction came from Royal Bank of Canada in 2007, following a letter from the Office of the Superintendent of Financial Institutions (OSFI) permitting the sale of covered bonds.
In 2008, RBC returned along with Canadian Imperial Bank of Commerce and Bank of Montreal. There were another three transactions in 2009, but it was in 2010 that the Canadian covered market really started to grow. Toronto Dominion Bank and Bank of Nova Scotia issued debut deals, and RBC sold the first trade in Canadian dollars. CIBC launched deals in Swiss francs and Australian dollars, and in total 11 transactions worth $16.7bn were brought to market in 2010.
Though Canadian banks have issued across five currencies, their comparative advantage lies in accessing the US buyer base, where they benefit from a minimal basis swap and geographic proximity. Dollar denominated paper accounts for almost 70% of Canadian issuance in 2011, and Canadians make up roughly half of total dollar covered bond supply.
European issuers bringing dollar trades typically pay around twice that of their Canadian peers. Toronto Dominions latest five year tranche was priced at 73.4bp over Treasuries, compared to a $1bn five year trade from Swedbank which was priced on August 24 at 113.9bp. TDs three year tranche was priced at 58.4bp. HSBC sold a $1.25bn trade in the same maturity at 92.75bp in June.
This pricing advantage is due in part to regulation that requires a Canadian bank extending a high LTV loan to take out insurance which covers the entire amortisation term of the mortgage, along with the principal and interest payments. The largest institution in this market is the state owned Canadian Mortgage Housing Corporation. Though this insurance does not amount to perfect triple recourse or a government guarantee on the covered bonds, the fact that each loan is individually insured by an entity whose obligations are backed by the full faith and credit of the Government of Canada is an important consideration for investors.
"Out of the seven programmes, six have CMHC insured mortgages," says Riz Sheikh, head of covered bond structuring, Americas, at Barclays Capital. "Typically there is a differential in the secondary market, with CMHC insured covered bonds pricing tighter."
Covered bonds have also allowed Canadian banks access to new groups of buyers.
"There are investors in covered bonds that may not invest in unsecured products. The quality of Canadian collateral, the CMHC guarantee and the credit ratings all allow banks to reach rates buyers," says Cathy Cranston, senior vice president, financial strategy and treasury, Bank of Montreal Financial Group.
Covered bonds also enjoy favourable treatment in almost all regulatory initiatives. Under solvency II, triple-A rated covered bonds are assigned a low capital charge, which has prompted insurance companies with little or no previous involvement in covered bonds to set up specific portfolios. As part of Basel III, covered bonds are included in the range of liquid assets that will comprise a Liquidity Coverage Ratio. This has resulted in bank treasuries setting up covered bond portfolios for the first time.
"Canadian issuers are tapping into those broad themes," says Sheikh, adding that in a post-credit crisis environment where liquidity is key, it is important to have multiple options to access funding and liquidity.
"While Canada has a strong domestic securitisation market its always prudent to have the ability to access other markets when particular funding windows close," he says.
The next step for the Canadian market will be domestic covered bond legislation. A much anticipated consultation paper was released by the Department of Finance in May, with responses received from law firms, rating agencies and other market participants in June.
"The next logical step is for a copy of the draft legislation to be tabled in the house," says Andrew Fleming, senior partner at Norton Rose.
This is likely to be a relatively straightforward process, unlike the US where there has been acrimonious debate between supporters of the US Covered Bond Act and the Federal Deposit Insurance Commission regarding the particulars of legislation.
"As we now have a majority government I would expect it to be quite simple to take a piece of legislation such as this through the parliamentary process," says Fleming. "Its not controversial and I would not be surprised if everything was wrapped up by the end of the year."
The popularity of Canadian covered bonds in their current common law format means that the benefits of legislation will not be extensive. US investors are clearly happy with the collateral and credit fundamentals of Canadian banks.
"We believe existing structured covered bond programmes provide all the necessary support to investors in the event of a default, but are supportive of the development of legislation to provide greater clarity and certainty" says Cranston.
The structured approach has worked well, and all existing programmes have received triple-A ratings.
Fleming, however, says that this is no assurance that at some point there might be some change that negatively affects covered bonds.
Though there are no specific dangers avoided by enshrining the rights of investors in law, Canadian laws relating to bankruptcy and insolvency, as in other jurisdictions, are constantly evolving.
"There are changes in the way the courts apply various statutes, which in turn are there to accommodate changes in the system; different customs, different products," Fleming adds. "The courts have a great deal of leeway on certain statutes, and though no one has ever made an order which would negatively affect a covered bond holder the product has not been around that long."
It is hard to imagine a Canadian issuer getting into severe financial difficulties, but in such an instance the courts could feel compelled to interpret applicable statutes in a manner more preferential to depositors than covered bondholders.
Legislation, says Fleming, prevents this uncertainty.
Ratings agencies share this perspective. Standard & Poors, for example, says that while legal recourse to the cover pool is achievable through a contractual covered bond framework, investors generally see covered bond legislation as providing increased legal certainty following an issuer default. This in turn was evidenced by tightening spreads in the secondary market following publication of the consolation paper.
"It may have been a temporary phenomenon, but it indicates a positive response from investors," says Walker. "Were seeing new buyers participating, and were hopeful it will expand whether thats due to legislation or the strong performance of existing trades."
Despite the benefits of legislation, elements of Canadas regulatory regime have proved cause for concern. In 2006/2007, when covered bonds were first being mooted, opposition from deposit holders, as in Australia, meant that regulators had to compromise and limit the products use. In this case the limit decided on by OSFI was 4% of total assets, which is much more stringent than limits in other jurisdictions.
"We are supportive of the 4% limit being raised, though at present its not an issue for BMO," says Cranston.
Looking at the steady development of the market, however, it may become a constraint for some banks in the near future. Though BMO may have a comfortable amount of room to issue, not all issuers are in the same position.
Banks approaching their limit may lobby for an increase. The limit also prevents smaller banks from using covered bonds, and as such risks creating a two-tier market.
"By maintaining that 4% cap it means there are some residential mortgage lenders in Canada who would not be able to participate in the covered bond market," says Jerry Marriott, managing director, Canadian structured finance at DBRS. "They are small enough that 4% of their balance sheet would not amount to $1bn, and unless you have at least a couple of billion dollars to issue banks wont enter the market due to time and cost of setting up a programme."
DBRS has not expressed an opinion on whether a cap on issuance is necessary, but has suggested that the cap could be reviewed at a later date.
OSFI has also placed a limit on over-collateralisation, which cannot exceed 10%. On one hand this is one of the more direct measures for combating asset encumbrance. Though covered bonds lower an issuers overall funding costs and allow access to new investors, senior unsecured investors suffer an increase in loss-given-default. This is often marginal when just the covered bonds are taken into consideration, but can become important when OC is increased to levels commonly seen in Europe. On the other hand, the cap limits the ability of issuers to respond to rating agency requirements, which have focussed more on asset liability mismatch and liquidity, forcing issuers to hold more OC to maintain a triple-A rating.
In response to the Canadian consultation paper Standard & Poors said that in general the introduction of specific covered bond legislation would be positive, and likely provide further assurances for investors. However, the rating agency also noted that such a cap may limit an issuers ability to manage and support its covered bond programme. Under its current analytical approach, S&P said such a cap may constrain the ability of issuers to achieve or maintain the highest potential ratings.
Moodys has been more direct, saying it would be unlikely to assign such a rating to covered bonds issued by a Canadian bank rated A3 without over-collateralisation of more than 10%.
Awash with liquidity
Canadian rating agency DBRS, however, does not share these concerns.
"We have no issue with a 10% cap on over-collateralisation if the only assets permitted in the cover pool are residential mortgages," says Marriott. "Were simply saying that if other types of assets are permitted in the cover pool then there could be a problem as more than 10% OC might be required."
In Canada, the domestic banks that are the big players in the Canadian residential mortgage are very well capitalised, and have requirements that accompany their mortgage business.
"In addition to the capital that must be held against the mortgage, federal regulation requires that if the loan to value ratio is greater than 80% on any residential mortgage, the bank must take out mortgage insurance," says Marriott.
Beyond this there are other aspects that provide greater liquidity. The National Housing Act Mortgage Backed Securities market allows banks to bundle up insured mortgages and sell them into the institutional investor market. Canada also benefits from a highly active Canada mortgage bond market, started by CMHC in 2001.
In Canada delinquencies of more than 90 days were around 40bp in the first quarter of 2011, which has been consistent for the last 15 years. In the US by comparison, delinquencies and foreclosures peaked at around 7%, and now are around 5.5%.
"The upshot of this is that not only are Canadian banks in a very different position, but the performance of the underlying assets has been dramatically different." says Marriott. "This and the support mechanisms in place give us comfort that there will be adequate liquidity in the market."
Whether a covered bond law is the right place for prudential legislation is a fundamental policy question. Many market participants believe that when dealing with federal legislation, such decisions should fall to the prudential regulator, in this case the OFSI.
"The legislation can dictate that the over-collateralisation will be capped at a level determined by the regulator, which removes the need for parliamentary approval to any change," says Fleming. "Another possibility is empowering the covered bond registrar to establish the amount of OC from time to time, which makes it even easier to change."
Though yet to be determined, Fleming adds that with financial oriented legislation there is an inclination to place the decision with the regulator.
"Its very rare to hardwire a number into legislation given that amending it is sometimes not practical."
Legislation should also expand the investor base for Canadian paper. Despite strong fundamentals, triple-A ratings and insured collateral, some buyers are prevented though regulation or other strictures from participating in covered bonds not issued under legislation. This should be especially beneficial in jurisdictions other than the US, where buyers are already comfortable with Canadian covered bonds, and will simply get the added benefit of a legislative framework.
"More US investors will look at the product with legislation in place, and in Europe it will allow certain new investors to participate," says Hiren Lalloo, director, securitisation finance at RBC Capital Markets. "Legislation will further support the current robust Canadian structure removing restrictions on some buyers and lowering the risk weighting for others."
All Canadian issuance has thus far been issued in 144A format, which exempts the issuer from full SEC registration. Though full registration would allow Canadian banks to tap a wider investor base it carries onerous disclosure requirements.
"SEC compliance is ultimately subject to a cost benefit analysis," says Sheikh. "One advantage is that it expands the investor base and improves the pricing outcome."
Canadian issuers, however, already price at levels that leave little additional room for spread tightening.
"If an issuer is pricing at 30bp-40bp for a five year, the spread may not come in much, whereas for a European issuer pricing at 70bp-80bp full registration becomes more advantageous."
The cost of disclosure requirements mean SEC registration has not been pursued by Canadian issuers. However, those banks with a branch presence in the US can access a larger investor base using Rule 3(a)(2) exemptions, which has similar disclosure requirements to 144A trades.
"There might a few issuers who take advantage of this option," says Sheikh.
The US investors are already comfortable buying Canadian paper on the basis of the credit, and all the common law programmes enjoy triple-A ratings. Cranston says there is no pressing need for SEC registration given the ease with which banks can issue in 144A format.
Slow and steady
Despite the bright future of Canadas covered bond market, a big rise in issuance or the addition of new programmes is unlikely in the short term. Further supply into Europe and other jurisdictions remains constrained by the lack of a favourable basis swap. Canadian banks brief forays into Australian dollars were made when the Australian market became as attractive as the US.
"As a treasurer you look to access all markets when they are available at the right price," says Sheikh. "For Canadian issuers, there is not much of a currency basis swap cost for US dollar issuance, whereas if you issue in euros and swap into dollars, depending on the tenor, swap costs may add 15bp-25bp to overall funding costs."
In addition investors in other regions may demand a higher spread than US buyers who are more familiar with Canadian credits.
This reliance on dollars is not problematic given ample investor appetite, and following the downgrade of US Treasuries by S&P UniCredit analysts suggest that some investors with a dedicated triple-A policy may turn to Canadian covered bonds. However, the larger banks for which covered bonds make economic sense have all set up programmes. For those prospective issuers not prevented by the 4% cap from entering the market, the presence of legislation is unlikely to make the difference.
The Canadian market will thus likely remain a concentrated one, though even with an issuance cap in place it should continue to deepen. Having become the foundation of the dollar segment, Canadian covered bonds are set to become an increasingly important part of the global market too.