True, the timing of the first two deals, launched in November by ANZ and Westpac, was far from ideal. Nevertheless, for issuers, investors and intermediaries, the opening of the Australian covered bond market was well worth waiting for, given the diversification it brings to the global asset class.
To discuss the longer term potential for this market, all the front-line issuers gathered in December at the DZ Bank Australian Covered Bond Roundtable.
Participants in the roundtable, which took place in
Sydney, were:
Joanne Dawson, deputy group treasurer,
Westpac Group, Sydney
Arnold Fohler, head of debt capital markets,
DZ BANK, Frankfurt
Tim Hughes, treasurer, Suncorp Bank,
Brisbane
Christian Joannidis, head of group funding,
National Australia Bank (NAB), Melbourne
Simon Maidment, head of group funding and
execution, Commonwealth Bank of Australia (CBA),
Sydney
John Needham, head of structured funding,
group treasury, ANZ, Melbourne
John Sorrell, head of credit, Tyndall Investment
Management, Sydney
Martin Wehling, head of debt origination, Asia/Pacific,
DZ BANK, Singapore
Moderated by Phil Moore, EuroWeek
EUROWEEK: In 2007, one Australian banker told EuroWeek that covered bonds were "conceptually abhorrent" to Apra [the Australian Prudential Regulation Authority]. What has changed to soften the regulator’s stance?
John Needham, ANZ: Apra’s role is to protect depositors, and clearly with a covered bond a certain amount of collateral is moved away from the benefit of depositors in favour of covered bondholders. Apra’s interpretation was that this was not permitted under the Banking Act.
Equally, Apra’s role is to implement government policy and it recognises that government policy is to support the diversification of the investor base for the Australian banking system. Consequently, Apra has supported the implementation of the new banking legislation.
Part of that support is based around establishing a limit on the amount of assets that can be included in the cover pool. This has been set at 8% of Australian assets, which Apra feels is an appropriate limit. It allows for banks to achieve funding diversification and at the same time ensures continued support for depositors.
EUROWEEK: Was there lobbying by the Australian banks or any other trigger that accelerated the legislative change?
Christian Joannidis, NAB: There was active lobbying via the Australian Bankers’ Association, which all the banks around the table were part of. The engagement across all the various stakeholders in terms of getting the legislation passed was very interactive. It was aimed at ensuring that the conditions under which the Australian banking sector operates are broadly consistent with international standards in terms of access to diversified funding sources.
Arnold Fohler, DZ BANK: Was there also some international lobbying by investment banks to complement the efforts of the Australian banks?
Joannidis, NAB: Local banks were the key drivers. We drew on examples from offshore of what covered bond legislation or a covered bond programme may look like. So for the ABA and the Treasury it was a case of adopting the elements of legislation and structuring that are recognised as best practice offshore and applying that in an Australian banking context.
Simon Maidment, CBA: John’s alluded to the concept of depositor protection in the Banking Act, which we didn’t have before 2008. When that was introduced it was certainly a constructive structural change to the banking landscape in Australia. It meant that depositors had an additional layer of protection that they hadn’t previously had, and therefore a limited amount of asset encumbrance became possible both from a government and an Apra perspective. EUROWEEK: How do you view the Australian regulations compared to markets such as New Zealand and Canada?
Joanne Dawson, Westpac: It’s a strong legislative structure because, as Christian said, we have chosen to adopt some of the principles of offshore markets, both in terms of legislation and of the structure of covered bond programmes. That would suggest our legislative framework is at the stronger end of the spectrum.
Needham, ANZ: The comparison really has to be with the UK, because neither Canada nor New Zealand yet have covered bond laws, although both have legislation in the pipeline. It made sense to use the UK as the base, given the similarity of the common law legal systems, which are quite different to the civil law legal systems which exist across Europe.
Tim Hughes, SunCorp: The industry was unanimous in wanting to go down the legislative rather than the structured route. There wasn’t much argument about that because everybody agreed that we wanted to have a very strong legislative environment from the outset given that we were starting behind the rest of the world. I think that was the right move.
EUROWEEK: Are there any weaknesses or limitations in the legislative framework that issuers or investors would like to see addressed?
Dawson, Westpac: The feedback we’ve had from investors suggests they have a high degree of comfort with the legislation and structures that have been put in place.
John Sorrell, Tyndall: From an investor’s viewpoint, the fact that there is a well established legislative framework and that there are limits such as the 8% ceiling, give a degree of confidence that a number of other jurisdictions don’t provide.
Fohler, DZ BANK: Has the passage of the Australian law led New Zealand to accelerate introducing covered bond legislation?
Needham, ANZ: The RBNZ released a discussion paper on legislation in December, which suggests that we will see legislation in the first half of 2012. We expect the legislation to be similar to Australia and the UK.
EUROWEEK: Martin, how would you say the Australian legislative framework compares with Europe?
Martin Wehling, DZ BANK: Looking at the pre-sales documentation and in our discussions with the agencies, we were surprised by some of the numbers assigned to the Australian pools compared to, say, the UK, which, as John said, is probably the closest comparison from a legislative perspective. The percentage of over-collateralisation required, for example, was a surprise. We thought Australian cover pools would get better numbers compared to the UK.
I would be interested to hear the views on this from the borrowers around the table who have been through this discussion with the agencies. Were you expecting these kinds of numbers, given that we’ve seen RMBS issuance out of Australia performing extremely well for many years?
Needham, ANZ: Our numbers are pretty conservative by comparison with other jurisdictions. We may need to do some more work with the agencies on this. But this probably isn’t a very sensitive issue to us at the moment, given that we have such large portfolios of mortgages that are available as collateral. In the case of ANZ, we have a portfolio of around A$170bn and only have about A$180m of RMBS outstanding.
Joannidis, NAB: It’s important to highlight that this is still a new product. Over time, ratings agencies may refine their methodology in terms of looking at these cover pools.
Wehling, DZ BANK: Perhaps Tim would like to come in here? Suncorp has been a strong RMBS issuer for many years and you have no doubt had discussions with the ratings agencies about the level of over-collateralisation you will need for your covered bonds to reach a triple-A rating. This seems to be somewhere in the mid-to-high 20s, which is obviously very high.
Hughes, Suncorp: Yes, it is. But remember that covered bonds in Australia have come at a time when all the ratings agencies have been looking at their methodologies globally on a number of levels. There’s a lot going on in the ratings agencies’ world, so I would agree with John that, over time as things settle down, we will see some changes there, perhaps leading to a less conservative approach.
I would certainly like to think so. As you say, the way our RMBS has performed gives us a pretty strong argument.
Needham, ANZ: If you look at the performance of Australian residential housing loans, the level of delinquencies and write-offs in our portfolios is in the area of 2bp. It has been an exceptionally low number for an extended period.
Sorrell, Tyndall: It is true that delinquencies have been low for a long time. But we have never seen the Australian market being tested in the way that Europe and the US have been tested over the last five years.
As an investor I don’t want the ratings agencies to suddenly become very benign and assume that Australia will always be a better performer. What I do want the agencies to do is to standardise their methodology across all jurisdictions.
Needham, ANZ: Yes, but there are key differences in the way mortgage markets operate. The Australian market is characterised by full recourse loans, which is very different to what you see in most states in the US and in investment loans in the UK where you have limited recourse to the property. Limited recourse facilities of the sort you see offshore have an effect on the way borrowers service their loans.
Another important consideration is that Australia is mainly a variable rate mortgage market, which means that if the economy softens there is monetary policy available to the government allowing for rates to be reduced, which flows straight through to the economy.
The market is also based largely on an originate-to-hold model, which means that underwriting standards remain very high right across the industry. All these elements make the Australian market very different from the US or the UK.
Fohler, DZ BANK: The concerns of our research team have not been with the legislative framework. Their questions have related more to the operational side — such as how to separate flows dedicated to the cover pool from other claims upon issuer insolvency and so on.
Maidment, CBA: The Pfandbrief market is obviously a very long-standing and successful market. But wearing an investor’s hat, the co-mingling risk that exists in that market where you don’t have separation of collateral presents more of a risk than the Australian system where you have a very clear structural separation of the collateral pool.
Similarly, as we looked at the European market we asked ourselves, why would an investor buy a bond where they couldn’t measure the transparency of the collateral pool, although that is the whole nature of some of the longest-standing covered bond markets? To us, it is second nature to assume that investors will want as much granular information as possible about the cover pool.
In Australia our background is more of an asset backed structural framework where we would expect to see those minimum transparency criteria observed regardless of whether we were selling or buying the product.
That is an especially interesting contrast in the current market environment, in which some issuers may go through periods of financial stress, nationalisation and recapitalisation. Historically, the traditional covered bond product has been able to exist without presenting investors with credit issues. But is the current environment going to be one in which we are presented with real live credit tests?
We’ve had real live tests of what happens when an ABS issuer defaults, and what the procedure is when CDS are triggered by credit events. It will be interesting to see how the co-mingling structure in the Pfandbrief market reacts to similar real live tests. If the structure can withstand these pressures, it will be comforting to those of us who question that model and prefer to have one that compartmentalises risk.
Sorrell, Tyndall: As an investor I’d prefer not to have all the assets co-mingled. Pfandbriefe are not as natural a fit for our portfolios as they are for German investors. We have participated in the Pfandbrief market, but we have done so cautiously, and with an element of discomfort with the structure relative to some of the more recently developed covered bond markets.
Joannidis, NAB: As a group we’ve been active for many years visiting offshore and domestic investors and talking about our credit, the property market and the relative strength of the economy. So it’s now more important to talk to investors about the legislation and the structure of our covered bonds and how that compares to other jurisdictions.
EUROWEEK: Does this go back to the short-lived debate we had a few years ago about whether covered bonds should be seen as credit or rates products?
Maidment, CBA: Remind me what a rates product is these days!
Sorrell, Tyndall: The few covered bond products that have been sold into Australia were always treated as credit. There was never any question of seeing them as rates products and frankly I find it hard to see how they can be regarded as rates products. It is essential to understand and analyse the issuer.
Fohler, DZ BANK: I always found the debate about rates versus credit products in the covered bond market to be artificial and too dogmatic. The success of the highly liquid Jumbo product with market-making commitments led some people to define the Pfandbrief as a rates product. In the late 1990s some of the members of the covered bond community even called the public sector Pfandbrief a quasi-Bund, which was rubbish. It was a marketing gimmick that was overdone.
Dawson, Westpac: There doesn’t seem to have been much debate in Australia as to where covered bonds sit. Most people accept that they are credit products.
EUROWEEK: This brings us on to the Australian housing market. On your roadshows, what sort of questions have investors been asking about the Australian market? The Economist stirred up some controversy recently when it argued that Australian house prices were overvalued by 56%. The Economist said that made the Australian market the most overvalued in the world, comfortably above second-placed Hong Kong. Are investors uneasy about this?
Maidment, CBA: This has been a factor that we’ve had to address as we’ve gone round the world for a number of years now. There hasn’t been the same correction in Australian house prices that we’ve seen in some other jurisdictions. We believe that there are some very rational reasons why this is the case and we always make sure that we explain these to investors.
Headlines sell magazines and the article you refer to has focused on one side of the debate. The other side of the debate has been presented in Australia, and has focused on issues such as house prices versus income growth, the fact that the population dynamic in Australia is different to other jurisdictions and so on. We’ve done a lot of work over the last two or three years collectively to put the other perspective of that debate on the table, which I believe investors have appreciated.
Looking more broadly at the credit story of the Australian banks, mortgages make up the dominant part of the balance sheets of all the major banks here. But while we have exposure to the mortgage story, investors also take comfort from some of the areas we don’t have exposure to. Typically the Australian banks have not been exposed to areas like ABS defaults in the US or the sovereign debt crisis in Europe.
Obviously there are no risk-free investments anywhere anymore but I think investors are becoming more comfortable with Australia’s capacity to withstand external factors, such as a slowdown in the Chinese economy.
Hughes, Suncorp: I agree, although the first question we’re asked when we walk into an investor meeting is when is the Australian housing bubble going to burst.
Dawson, Westpac: Two or three years ago this was definitely the first question that was asked on roadshows. These days it is a question we’re being asked less and less. Even on covered bond roadshows where you’d expect more questions about the housing market, we’re finding investors are becoming more comfortable on that subject.
Maidment, CBA: Of course there is the potential for a house price correction, but when you look at the average loan to value ratios across our portfolio they are incredibly low. Arrears are one thing but losses are quite different. They are a function of the over-collateralisation that is embedded in the underlying mortgage portfolio, and as John said, investors have taken comfort from how conservative originating standards are in Australia.
Fohler, DZ BANK: But is there any risk of a self-fulfilling prophecy whereby outsiders rather than insiders believe that a bubble may have been created in the Australian market?
Maidment, CBA: People from outside the country will look at Australia and ask why is this the only developed market that has not seen a 20% correction in prices. A number of factors explain that story but whether or not you give credence to them is up to the individual.
It’s not as though house prices have been following a lineal upward trend in Australia for 15 years, which people seem to forget. Over the last 12 months we’ve seen house prices come off a bit, which is exactly what you would expect given the tightening in monetary policy. Investors will generally be pleased that the government is exercising some control over rising asset prices and that Australian house prices have moderated as a result.
Let’s also not forget that Australia is seeing very strong income growth while some other economies where the housing market is under pressure are seeing minimal income growth. Household debt to income levels and house price to income ratios in Australia are moderating, and that is the sort of soft deleveraging that policymakers will be happy about.
Wehling, DZ BANK: Australia also has adjustable or floating-rate mortgages which is unusual in a global context, and which means that the central bank has the ability to respond quickly. This in turn has more of a direct impact on borrowers’ ability to repay mortgages than the Fed or the ECB has.
Dawson, Westpac: The transmission mechanism in Australia is very fast. Although mortgage rates aren’t explicitly linked to the RBA’s cash rate there has been a very clear relationship between this rate and the banks’ outstanding variable rate mortgage products. Remembering though that the other big influence on variable rate products is the banks’ cost of funds, which is driven by global market forces.
When you combine the flexibility of Australia’s monetary and fiscal policy with the structural features of the mortgage market, such as the full recourse to the borrower and supply-demand dynamics, there are still a lot of positives in the market.
Fohler, DZ BANK: For the sake of European investors who may not be very familiar with the Australian market, what are the drivers of the housing market — for example housing starts — and how important are net migration trends?
Maidment, CBA: The population growth story in Australia has been strong. It’s hard for people who haven’t been to Australia to understand why, when we have one of the lowest population density ratios in the world, there is still a shortage of housing in this country. There is an inelastic supply curve in Australia primarily due to the fact that state governments control the re-zoning of land for residential development.
While Australia has one of the lowest population densities in the world it has one of the highest urbanisation rates. Populations are very densely concentrated, primarily within the three capital cities of Sydney, Melbourne and Brisbane on the Eastern seaboard. These cities have become very large and the state governments have been reluctant to allow further urban expansion, partly because they’re responsible for putting in all the infrastructure that would be required as a result.
Unlike in Europe, there has been a reluctance to take on debt at all levels of government in Australia. This has created a lack of supply response to strong population growth, which was running at close to 2%, which is pace you’d expect to see in an emerging market. It has now come back a little, most of which is due to our ability to open and close the migration taps according to the needs of the labour market.
Another indication of the shortage of housing is the rental market, which is growing at around 1.5 times CPI, and where the vacancy rate is incredibly low. In Australia you don’t find huge swathes of newly-built houses sitting empty.
EUROWEEK: Does that apply equally across the three Eastern seaboard cities? Are the main urban property markets similar?
Maidment, CBA: Each is very different. People talk about a multi-speed economy in Australia, which is larger than continental Europe with a mix of economic influences across the country. Those different markets are highly but not perfectly correlated. At the moment arrears are slightly higher in jurisdictions such as Queensland which have been exposed to the floods and the impact that the strong currency has had on tourism. In some of the other jurisdictions you’ll see lower arrears rates and better house price performance. To an outsider the markets may look very homogenous, but there are differences across the states, which generates some degree of diversification in our portfolios.
EUROWEEK: Joanne made an interesting point about international investors being more relaxed than they used to be about the Australian property market. Have other borrowers been given a similar impression on their roadshows?
Needham, ANZ: Investors take a level-headed approach to articles such as the one you mentioned in The Economist. On our roadshows we have addressed the same issues that Joanne and Simon have already talked about, and investors’ responses have been similar.
In the Australian market there is the additional feature of indexation of property prices which is also a source of comfort for investors.
Wehling, DZ BANK: During your roadshows, was this a big discussion point between you and investors? Do you use indexation as a unique selling point for Australian covered bonds?
Needham, ANZ: I don’t think we use it as a unique selling point. Part of the roadshowing process was to present our covered bond as our gilt-edged product and to make sure it benchmarked well against all the north European jurisdictions. Indexation is used in the UK and the Scandinavian countries and we are implementing it within our structure in a similar way.
Wehling, DZ BANK: Indexation can be a question of definition and the sort of index and LTV you are applying. Even among the five banks here, two different indices have been used. One is the quarterly Australian Bureau of Statistics (ABS) Price Index; the other is an index published by RP Data. Did any investors ask during the roadshow why issuers chose to use these indices?
Maidmont, CBA: I think investors are happy to see indexation being used and take comfort that it provides a mitigation against the potential for house price correction. Once investors are reassured that indexation is being used they’re not too fussed about which specific index is chosen.
Wehling, DZ BANK: Indexation in the Australian context protects the investor on the downside but does not give any additional benefit on the upside. Is that important for investors?
Dawson, Westpac: The choice of index certainly wasn’t a big point raised by investors when we were roadshowing. I agree with Simon, that once investors recognised that indexation was part of the structure they were agnostic as to which index we used.
Joannidis, NAB: Our experience was similar and it made sense to include indexation as part of our programme. The majority of enquiries we received regarding indexation were from UK investors.
Needham, ANZ: When we were roadshowing we had a lot of questions about indexation largely from the biggest six to eight investors in the US and a number of investors in the UK. The subject came up at every meeting and we spent a fair amount of time explaining to investors how it was being implemented and why we selected the index that we did. But the key point was the one that Simon made, which is that indexation provides protection against a substantial fall in property prices, so it was seen as an important feature to include.
EUROWEEK: Moving on to the potential growth and size of the Australian covered bond market, the 8% limit suggests a potential issuance volume of between A$140bn-A$160bn. Presumably the lion’s share of that total will be accounted for by the five banks around the table?
Hughes, Suncorp: We’ll only be around A$3bn-$4bn of that total.
Dawson, Westpac: A total issuance volume of around A$150bn is probably about right.
Fohler, DZ BANK: Of that total, how much would be accounted for by the big four?
Maidment, CBA: About 90% of the assets in the Australian banking sector are held by the big four, and issuance would be on a pro rata basis.
EUROWEEK: If we see some of the other smaller banks in the market, will they be able to issue on a standalone basis or within a pooled structure?
Hughes, Suncorp: That’s an interesting question and one that was raised early on. Being the fifth largest bank here today, we’re comfortable that we can issue in the triple-A space. Over-collateralisation will obviously be an issue for us.
Issuance from other regional banks such as Bendigo and Adelaide and Bank of Queensland is a possibility. The question of aggregation has been discussed with the Treasury and Apra. There hasn’t yet been a big push for that and I don’t see anything happening in the short to medium term.
Maidment, CBA: The subject of aggregation doesn’t really impact us from an issuer’s perspective although it would be relevant to us as potential investor in covered bonds.
I can’t see why there needn’t be a market in Australia for double-A rated covered bonds. Some of the regional banks may not be able to get up to the triple-A level. For banks with a high triple-B or low single-A rating, access to the senior unsecured market has been somewhat limited. If they could use a covered bond structure to produce a double-A security that is RBA-eligible, that is likely to be something that will appeal to bank investors and potentially give those in the institutional space greater capacity to buy those names as well. So I would see that as a potential area for development.
Coming back to the question of aggregation — this is only really likely for the credit unions or building societies without the critical mass to issue. I can see the smaller regional banks having sufficient critical mass to do so if it makes sense from a funding perspective, and there would certainly be demand.
For the layer below these banks there would be structural challenges involved in aggregate issuance. But there would also be challenges in the sense that these entities don’t have ratings.
EUROWEEK: Would the bank borrowers like to comment on how they see the covered bond market complementing their existing sources of funding, and on what their plans are to build up yield curves in US dollars, euros and Australian dollars? Tim, does your relatively small issuance programme militate against being able to build a yield curve in a number of currencies?
Hughes, Suncorp: We’re looking closely at whether we should be focusing domestically or putting together a global programme. For us, it’s all about diversification of our funding base. We’ve been issuers in the senior unsecured and RMBS markets for a number of years, and we’ll continue to use those avenues in addition to covered bonds.
Suncorp has a good reputation in the market globally. The strategy for us would be to offer a spread to the majors with very similar collateral and cover pools that will be well over-collateralised. From the initial work and roadshows that we’ve done we believe there would be considerable investor appetite.
EUROWEEK: Would you also expect to tap into new sources of investor demand?
Hughes, Suncorp: We would certainly hope to tap into some new sources. We were a very heavy issuer of government-guaranteed bonds in 2009, particularly into the US market. We believe there will be some appetite as that government-guaranteed debt runs off.
EUROWEEK: Joanne, how do you see Westpac using the covered bond market, in terms of currency, tenor and in terms of complementing existing funding sources?
Dawson, Westpac: It acts as a complement to the other issuance we do, both on a senior unsecured basis and in the secured RMBS market. It will be an important contributor to our overall funding programme and it will become more so as we start to see repeat issuance from the other Australian majors.
We see it as a market we can issue into to diversify our investor base, so it will be key for us to attract investors we wouldn’t otherwise have in our senior unsecured or ABS issuance. We like the product and we intend to issue in the currencies that have a well developed covered bond market. We would like to issue in dollars and euros and also potentially in markets such as Swiss francs and sterling. We have the ability to issue in multiple currencies on a covered bond basis just as we do on a senior unsecured basis.
EUROWEEK: Based on the 8% limit, what is your likely annual issuance volume in covered bonds?
Dawson, Westpac: Looking at a five year maturity the 8% limit would lend itself to something in the A$5bn-A$8bn region on an annual basis. But we’re very receptive to market conditions and this would depend on the relativities of senior unsecured and RMBS.
Fohler, DZ BANK: What about issuance in Australian dollars?
Dawson, Westpac: Of course we’d like to see an Australian dollar covered bond market develop. But there is some investor education that needs to occur here which is already happening. A market will take shape here — it’s just a question of how quickly that happens.
Sorrell, Tyndall: If Westpac or any of the other majors were to issue covered bonds in Australian dollars, they would to some extent be cannibalising their existing senior unsecured investor base. We’re reasonably exposed to the domestic banking sector already and we don’t plan to extend our limits to any of these entities.
So we would probably be more interested in covered bonds from other countries. We’ve looked at Canadian covered bonds, for instance, because we don’t have access to their senior unsecured issuance in Australian dollars. We might also look at Europeans where we don’t have as much confidence in or familiarity with the underlying bank and where having a little more collateral may therefore be more appealing. But neither of those considerations applies to the Australian banks.
Dawson, Westpac: That’s a reasonable argument. Having spoken to a number of the domestic investors I think some share the view that buying covered bonds would cannibalise their senior unsecured limits. Others have an alternative way of looking at it, and would be willing to increase those limits. But we would also expect there to be some offshore interest in Australian dollar covered bonds. We saw from our government-guaranteed issuance in 2008 and 2009 that there was a reasonable amount of interest from offshore investors for triple-A Australian dollar product.
Sorrell, Tyndall: Speaking on behalf of my offshore colleagues, they make a big distinction between a triple-A sovereign and a triple-A non-sovereign. Some clients may cross that bridge if they are hungry for Australian assets, but not all.
Don’t get me wrong. I’m not saying there will be no demand for Australian dollar denominated covered bonds for local banks from offshore investors, but I can’t see the Australian dollar market being the main issuance market for local bank covered bonds. Canadian banks find it is much more effective for them to issue into the US or Europe than in the domestic market.
Hughes, Suncorp: Issuers will go where the liquidity is. We haven’t yet had a test of how much depth and liquidity there is in the marketplace domestically. In the meantime most banks will veer towards the European and US markets.
Sorrell, Tyndall: It’s not just liquidity. It’s also familiarity. We’re very happy with local banks as senior unsecured issuers, whereas in other jurisdictions such as the US there will be investors who are less comfortable with Australian banks in unsecured format. Covered bonds can give them the extra comfort to get them across the line, whereas we’re already across that line.
EUROWEEK: Isn’t there also the complication that domestic investors remain very equity-oriented?
Sorrell, Tyndall: It’s true that there’s not as big a proportion of invested money coming into bond funds as in many other countries. But a bigger problem for our clients is that they’re getting very worried about the concentration of their exposure to banks, full stop. So we’re not being encouraged to extend our investments into banks, Australian banks included. In fact, one of our clients has recently even tightened its mandate, so that we’ve had our limits on Australian banks reduced. Our clients don’t have concerns about the sector, but for them, diversification is key, and they don’t view covered bonds as offering diversification away from senior debt.
Wehling, DZ BANK: Maybe Christian has a view on this, given that BNZ is the only bank so far to have done an Australian dollar issue? That’s in some way a domestic issue because it’s the subsidiary of an Australian bank issuing in this market.
Joannidis, NAB: I guess it’s a little different given that BNZ had not issued in the Australian dollar market previously. But I think the timing of that transaction, which took place when the Treasury was still looking at the development of covered bonds legislation, worked in BNZ’s favour. We were surprised on the upside by how well that transaction was supported.
The question that remains though is, how broad is the investor base that would support that product? We may get an offshore bid, and I agree that Asia is a likely hub of demand for triple-A covered bond securities. But that would represent incremental demand; it wouldn’t be the driver of demand for Australian dollar product.
Other areas of interest will be how much money locally will be dedicated to the triple-A mandates of funds and whether there is likely to be cross-over between demand for triple-A supras and covered bonds for example.EUROWEEK: Going back to the longer term plans that the banks around the table have for covered bond issuance, how do covered bonds fit into CBA’s overall funding plans?
Maidment, CBA: If you look at the maths, the quantum of potential covered bond capacity we have equates to about 25% of our long term wholesale debt portfolio. To the extent that we could issue about a quarter of our funding programme in covered format, it would make sense for us to do so. So in a year’s time I’d like to sit around a similar roundtable and say that we’ve issued in euros, US dollars, Australian dollars and some of the peripheral currencies and that we’ve started the process of building curves. But that is obviously a function of how markets perform and how investor appetite develops.
The other key point about covered bonds is that they will help us to extend duration. It’s not that we don’t have access to the 10 year part of the curve because we and most of the other big Australian banks have done 10 year dollars and euros. But there is obviously an economic cost involved in going that far out along the curve and covered bonds are going to make that cost more palatable. In an environment where we have the LCR [liquidity coverage ratio] and NSFR [net stable funding ratio] coming down the pipe, alternatives for extending duration are going to be welcome.
Needham, ANZ: Our story is pretty similar. We’ve seen strong deposit growth, which has kept a cap on the amount of wholesale debt we have to do. Like CBA, about 25% of our overall funding could be through covered bonds, which works out at about $5bn a year. We would expect that to be distributed between dollars, euros and Australian dollars, and we would aim to build out our curve by issuing one or two benchmarks per year in each of the main currencies. We would also look to issue in other currencies if opportunities to do so arise. It all comes down to diversification.
EUROWEEK: So would the choice of currency be driven principally by the pursuit of diversification rather than pure cost? In other words, would you be prepared to pay up in the short term for diversification?
Needham, ANZ: As a financial institution we clearly need to ensure that we minimise our funding costs over the longer term. We have a strategy for meeting that objective, and broadening the investor base is an important part of that process.
We’ve had one issue so far and there is plenty of scope for more investor education and marketing of our product, our structure and our mortgage market. As that occurs and as market conditions settle down, we believe that we will be able to issue in these sorts of volumes in a very cost-effective way.
The question then is also about tenor and terming out our funding. Our senior unsecured issuance is likely to be targeted largely at the shorter end of the curve, in the two, three and four year maturities, whereas we would expect our covered bond issuance to be in the five, seven and 10 year area. The sweet spot for our funding is five years because that reflects the profile of our mortgages. Although they generally have a maturity of 30 years, prepayment tendencies are such that mortgages’ average life is much closer to five years.
Joannidis, NAB: Tim made an important point earlier when referring to dollars and euros offering the greatest liquidity in the product. I would also agree that diversifying into other offshore markets such as sterling, or Swiss franc will also be valid for NAB.
Once the initial transactions have come to market and investors become comfortable with the pricing points that have been established, and more familiar with the structure, I would see covered bonds going hand-in-hand with our overall funding programme, alongside senior unsecured and RMBS. You would then assess key criteria of cost, tenor, diversification and so forth, on a transaction-by-transaction basis which would direct you towards the optimal market to access at any given time.
EUROWEEK: Do any of the borrowers here have the sense that Australian bonds will be viewed increasingly as safe havens? Moody’s has just said it sees threats to the credit quality of EMEA covered bonds in 2012, so perhaps Australia could benefit from any flight to quality that may occur?
Maidment, CBA: When we were roadshowing we had a tremendous response in Europe to the structure of the product, as I’m sure the other banks did. But let’s not forget that these are dual recourse instruments and investors were very keen to look at an issuer of a high credit quality standing that was as far away from Europe as you can get, both geographically and from a credit perspective. So yes, there is an opportunity for us to offer a differentiated product in the context of a market that will be put through more stress. Clearly there is downward ratings pressure across the European sovereigns and the European banks, which will put downward pressure on the ratings of European covered bonds.
We have a premier product and some very strong issuers, which is a good position to be in, given the current environment.
Fohler, DZ BANK: When introducing and selling new products, or — as in this case — products from new covered bond jurisdictions, issuers and intermediary banks are obliged to advise the investor base carefully and diligently, and that does not just mean the largest institutions like Pimco and Axa, or the central banks. These big investors already have their own risk analysts and a pretty sound understanding of the nature of the Australian economy and its financial institutions.
In Europe there is also a huge layer of ever more relevant smaller and mid-sized institutional investors who don’t have their own research teams, which is where we bankers need to step in and educate the investors. These institutions, which are already experienced covered bond investors, have a great openness towards Australian covered bonds and they appreciate and understand the strong ratings of Australian banks. But in contrast to five years ago when investors were happy to pick up anything with the covered bond label, they are much more selective. They will want to see the first Australian covered bonds come to the market and see them perform, then success will breed success.
Joannidis, NAB: I agree it’s early days and we need a number of transactions to come to market across several jurisdictions before we can judge the success of the product. So far, we’ve only seen dollar trades, but issuance in euros, sterling and so on, will all add to the story and allow investors to form their own view.
EUROWEEK: That leads on neatly to a discussion about the two dollar deals that have been done so far. John, as ANZ was the first to issue, how did you set about pricing your transaction?
Needham, ANZ: A lot of focus went into the question of pricing during the roadshow and in our discussions with investors over the course of the previous weeks and months. The available benchmarks were the curves that had been established by the Canadian issuers and also by some of the Scandinavians.
With their mortgage guarantee system the Canadians were perhaps seen as the lowest curve, while the Scandinavians were regarded as similar to us in the senior unsecured market.
There has been a relatively open discussion about how the deal went. We launched the deal during Asian trading hours and ensured that we would have support from Asian investors. It was a time of quite high turmoil in the European time zone, but it was a better day in the US where the Dow rallied. So demand continued to build throughout the day and we ended up with something like 67 investors in the book.
The popular perception is that the US market is relatively small in terms of the number of investors that can buy into the covered bond market, so you need to be certain of support from a couple of the largest accounts there. We were pleasantly surprised by the breadth of investors that came into the deal.
We offered a spread which allowed us to build a total book of $1.5bn, which we then scaled back to $1.25bn, and on the break the issue traded tighter. But market conditions are such that everything has become more difficult since then. Whether you look at Canadian banks, European banks or sovereigns, everything has widened out, and Australian issuers aren’t immune from what’s happening across the rest of the globe.
EUROWEEK: Joanne, could you talk us through the Westpac deal and what was learnt from that in terms of pricing, timing, distribution and choice of lead managers?
Dawson, Westpac: There has certainly been a lot of coverage of our deal, much of which has been correct and some incorrect.
Obviously the backdrop to the deal was a market that had been precarious for a few months. We made a decision quite early to go to the US dollar market, because of relative pricing but also because of the support that we have seen from investors in the senior unsecured US dollar market and because of our perception of execution risk in the various markets that were open to us.
ANZ had issued two days before and we had seen a lot of interest in the product from investors. We had also had a dialogue with a number of investors after our roadshow meetings. So we were comfortable that we would have enough orders from Asia, as well as from the US and Europe, to support what we saw as a minimum $1bn issue.
We were very cognisant of the uncertainty in the markets, but we were certain that a high proportion of the bonds had been sold before we even launched the deal, which helped us to minimise execution risk. We always planned to keep the time we were in the market to the minimum, so we launched at 9.30am and priced at 1.30pm. Obviously conditions deteriorated quite quickly during the time we were in the market, and in the period afterwards there was a lot of turmoil in Europe and dislocation in markets. The following week, for example, we saw Germany unable to clear its auction.
Wehling, DZ BANK: The difference in the distribution of the two deals was quite striking. More than 40% of Westpac’s deal went into Asia compared with roughly 20% in the case of the ANZ deal. Usually geographical distribution is pretty stable. Can you give any insights into why there was such a difference?
Dawson, Westpac: The only explanation I can give is that we’ve done an enormous amount of marketing work in Asia and we roadshowed our covered bond very intensively in Asia.
Fohler, DZ BANK: How much co-ordination has there been between borrowers in terms of market timing? Was ANZ concerned that the performance of its transaction may have been affected by Westpac coming so soon afterwards?
Needham, ANZ: It was well publicised that the Australian banks were planning to issue covered bonds in US dollars, euros and other currencies. These deals had been coming for 12 months and the issuers had been doing a lot of marketing with all the roadshows taking place at a similar time.
In normal conditions there would be ample capacity for all the Australian banks to issue into those markets, but what we have been dealing with is a time of exceptional stress across all markets. Following our transaction, market conditions became much worse.
Dawson, Westpac: I’d add that we all have funding programmes to complete on an annual basis, and with windows of opportunity for issuance opening and closing very quickly each bank needs to respond to those windows. You can’t block out certain times for individual banks.
Fohler, DZ BANK: If markets remain stressed, and senior unsecured funding is not available to the extent that you anticipate in your funding projections, is it possible that if we meet again in 12 months you will have replaced some of your planned senior unsecured funding with additional covered bond issuance?
Dawson, Westpac: Our funding requirement for the next year will depend on what is happening in the Australian economy and mortgage market, as well as on our deposits. But our liquidity position is comfortable so I don’t think we will be under any pressure to issue.
Needham, ANZ: That’s a very good point. The banks’ funding strategies have changed quite a lot since 2007 and the amount of short term wholesale debt funding on our balance sheets has been reduced significantly. We have all also seen very large increases in deposits, so we are comfortable with our funding programmes and with our ability to raise the volumes we need in senior unsecured funding.
Maidment, CBA: If you contrast the access that some of the European banks have to senior unsecured funding, to the access that Australian banks enjoy, obviously there are periods when the market isn’t open at all, but when markets are open we have constant reverse enquiry flows. So I think we’re all comfortable with our access to senior unsecured funding, but the issue today is the pricing of that access, which we don’t find very compelling.
Covered bonds may help from the perspective of relative pricing. But covered bonds for us are all about diversification. If we can get a quarter or a third of our annual funding done in covered bonds, great, but that will still leave us as very active issuers in the senior unsecured market and as regular RMBS issuers. We’ll look at sequencing deals to try to optimise the overall blended cost of those funds, but we will continue to issue in all three markets.
EUROWEEK: At CBA are you committed to a timeframe for issuing covered bonds?
Maidment, CBA: No. I don’t think any issuer should commit itself to timeframes for any transactions. But we have made it clear that we want to issue covered bonds. Our philosophy is that we’ve waited 10 years to issue and our expectation was that we’d issue our debut bond in 2011. The reality, given the performance of the market, is that we are now likely to issue in the first quarter of 2012. But our liquidity position is strong, so if we end up issuing in Q1 2012 instead of Q4 2011 it makes very little difference to us.
Joannidis, NAB: We’re in a similar position. Our balance sheet is in good shape and we don’t have any specific deliverables in terms of when we need to issue a covered bond. Obviously the market backdrop is quite challenging so we will wait for the right opportunity. It has still not been decided which market we will issue into and we remain flexible and open to considering all public markets for covered bond issuance.
EUROWEEK: Arnold, knowing the German market as well as you do, when Australian covered bonds are issued in euros, would you expect there to be a strong German bid for them?
Fohler, DZ BANK: Yes. When we had our Covered Bond Day in November, at which Simon represented the Australian banks, one German investor said it would take him less than a minute to get credit lines in place to buy an Australian issue. Another said he would need just five minutes to get the necessary credit approval. German investors are ready to invest in this market and I would expect them to be as supportive of the development of the Australian market as they have been of other jurisdictions.