Canadian covered bonds have become the cornerstone of the dollar market, and are issued with an ease that makes European public sector borrowers envious. In recent weeks while eurozone issuers poached the odd €500m by luring investors in with 20bp new issue premiums, Canada’s banks have sold well oversubscribed jumbo trades with coupons of less than 1%.
However, the Canadian market’s exponential growth is threatened by an issuance limit imposed by the Office of the Superintendent of Financial Institutions (OSFI), the country’s financial regulator. Its limit of 4% of total assets is not without precedent. Before the UK’s FSA began dealing with covered bond issuance on a case-by-case basis it expected to be informed by banks should their issuance exceed 4%.
Asset encumbrance is not an unwarranted concern, but as a limit, 4% was arbitrary then and it is arbitrary now. And unfortunately it has been used as the unofficial benchmark for conservative covered bond regimes. The FDIC suggested a 4% limit for US legislation, and Australia debated instituting a 5% limit before opting for a more lenient 8% cap.
Though several Canadian issuers still have room, CIBC has issued covered bonds equal to 3.6% of its total assets. Royal Bank of Canada is next with 2.8%, and in a market where $5bn can get done in a morning this cap will become a problem sooner rather than later.
Better then to raise the limit, or better still adopt the UK’s case-by-case approach which, with only seven issuers, would be easily manageable.
Canadian mortgages are among the best quality in the world. Not only are most of the underlying mortgage loans insured by a government agency but delinquencies of 90 days have been stuck around 0.4% for the better part of two decades. A claim against such assets makes it highly unlikely that recourse to the senior unsecured claim would be required in the event of insolvency.
Finally, for banks small enough that 4% of their balance sheet does not amount to $1bn, an increased issuance limit could make covered bonds cost-effective. The family of Canadian covered bond issuers would expand, and the risk a two-tier market that withholds cheap funding from smaller banks would disappear.