Covered bonds have enjoyed a long and unblemished history in Europe that dates back to 1769. Though many banks have come and gone since then, the ultra-safe bank financing tool has never experienced a default, and partly because of this appeal, covered bonds are now issued in as many as 30 countries across the world.
But the market’s development is far from over, with the South Korean and Singaporean regulatory authorities recently setting up frameworks that will encourage their banks to diversify their funding with covered bonds.
South Korea’s Covered Bonds Act came into force on December 19, 2013 and on December 31, 2013 the Monetary Authority of Singapore (MAS) set up a regulatory framework for the issuance of structured covered bonds.
But the two Asian regimes are quite different.
South Korea’s covered bonds are enshrined in a specific legislation that provides a detailed outline ensuring the high quality of assets and their segregation in the event of the issuer’s bankruptcy.
Singapore’s framework makes use of existing contract law and uses tried and tested securitization techniques that offer investors the same protection as legislative covered bonds.
In Europe legislative covered bonds enjoy a preferential status over structured covered bonds as regulated investors, such as banks and insurance firms, do not need to hold as much capital against their investment.
Though there are three generic structures, the protections afforded to investors are very similar.
The first model, which is used in Germany and is likely to be employed in South Korea, is based on direct issuance of covered bonds that are backed by ring fenced assets off the originator’s balance sheet. The second model, used in France, is where the originator establishes a specialist credit institution that issues the covered bonds and holds the collateral. The third model, which is used in the UK and is likely to be used in Singapore, is based on the originator issuing the covered bonds, which are guaranteed by a special purpose subsidiary that holds the assets.
But the speed with which South Korean and Singaporean issuers embrace issuance remains to be seen.
RAINY DAY HEDGE
Banks in these countries have strong unsecured credit ratings, generally in the double-A range, and most have good access to the capital markets at competitive funding levels. For this reason, the funding advantage of covered bond versus senior unsecured may not be compelling.
But both Canadian and Australian banks are also highly rated and the fact they’ve been active in covered bonds suggests there are other factors to consider besides the relative funding advantage.
Chief among these is the quest for investor diversification, which in times of stress can be a trump card.
“Covered bonds are the big rainy day hedge, but to make sure you have access when it does start to rain, you need to have set up the programme when the sky is blue,” says Bruce Cairnduff, head of debt capital markets for Asia Pacific at Crédit Agricole in Hong Kong.
South Korea’s Kookmin Bank, Woori Bank and Shinhan Bank have the largest mortgage market shares and are widely tipped as the strongest candidates for covered bond issuance.
Kookmin Bank will be the biggest beneficiary of the new law as it has the country’s largest mortgage loan book of W78tr ($74bn) and a market share of 24% according to Moody’s. Woori has the second largest mortgage book and a 15.4% market share, while Shinhan has a 15.2% market share.
KHFC IN FRONT
However, the first to issue off the new law may well be Korea Housing Finance Corp (KHFC), rated Aa3 stable. KHFC has been a regular issuer of covered bonds but in a structured format that was not based on the new law. Its last deal was a $500m five year that was issued in February 2013.
In Singapore, DBS Bank is widely tipped to issue the country’s debut transaction through Barclays and Deutsche Bank. The other two main Singaporean contenders are Oversea-Chinese Banking Corporation and United Overseas Bank.
Bankers are hopeful that one or two issuers will be seen within weeks.
“I would be disappointed if nothing happens before the end of the first half of this year,” says one banker involved in structuring a Singaporean deal. “But you can never be sure as bureaucracy and red tape have a habit of slowing things down.”
If issuance is to be seen, there will still be a question over the choice of currency. Korean and Singaporean banks have typically chosen the US dollar market for their foreign currency senior issuance, but for covered bonds they may choose euros.
This is because Europe has a far deeper covered bond investor base than any other global region, which should in theory mean greater demand, greater price tension and ultimately tighter pricing.
“The greater depth of Europe’s covered bond investor base compared to the US should translate to a lower overall cost of funds,” says Torsten Elling, head of covered bonds at Barclays in Frankfurt. “Their first deals could well be in euro format.”
But additionally, funding officials will closely look at the cross-currency basis swap. With the European economy looking weaker than the US, and its interest rate policy being more accommodative, the currency swap makes euro issuance the cheaper option versus dollars.
There are other longer term benefits that support Asian banks issuing their debut covered bonds in euros. Chief among these is that the first benchmark usually sets the standard against which all others reference their price. A competitively priced maiden deal should therefore help lower the cost of the ensuing funding, irrespective of whether that’s in euros or dollars.
“Dollar covered bond investors are more likely to compare against an issuer’s euro benchmark, suggesting Asian borrowers should be able to leverage the cheaper cost of euro funding with a subsequent US dollar benchmark,” says Elling.
Conversely, European investors of euro denominated covered bonds will barely ever look to the US market for a price reference.
SINGAPORE LESS WELL DEFINED
Whether European investors differentiate between Korean and Singaporean deals remains to be seen. But they are certain to take into account the fact Korea has a fully-fledged law, while Singapore has a regulatory framework that is less well defined.
Rating agency Fitch said the new MAS rules for covered bonds clarified important points on liquid assets and disclosure, but further work might still be needed before the first deals emerge. The absence of a dedicated covered bond law in Singapore and the flexibility that banks have to structure programmes underline Fitch’s expectation that Singaporean covered bonds will be structured through contractual arrangements.
However, the legal regime governing contractual issuance by special purpose vehicles (SPVs) in Singaporean securitizations has been strong and is effective in ring fencing collateral from an originator’s insolvency, Fitch says.
The updated Singaporean rules double the issuance limit to 4% of total bank assets from 2% originally. But this is still much lower than in other Asian countries.
Issuers must get MAS approval to set up a covered bond programme. Eligible cover assets are only residential mortgage loans with a maximum loan to value of 80%.
Banks need to implement appropriate governance arrangements, perform regular asset coverage tests and undertake regular stress tests. Banks must also establish an independent cover pool monitor, approved by MAS, and must submit an annual report to MAS and alert it to any breaches.
But as most Singapore bank lending is funded by deposits, issuance from the region is likely to be less than in Korea where banks depend more on the international capital markets for funding.
KOREA’S GREATER POTENTIAL
Fitch has estimated that “up to around $111bn of covered bonds could theoretically be issued under the [Korean] Act”.
Korea’s covered bond law offers investors better protection so is positive for credit, said rating agency Moody’s in January. The Korean law gives investors a priority claim over cover pools, as well as a senior unsecured claim for any shortfall if the pool is liquidated.
The act defines eligible issuers, the segregation of covered assets in the event of an issuer’s insolvency, the appointment of an independent cover pool monitor and regulatory reporting requirements. These provisions are similar to other jurisdictions according to Fitch.
Korean issuers must manage cover pool assets separately from other assets and keep ledgers on cover pools, which will strengthen asset segregation and legal protection, said Moody’s. The law also calls for a separate system to manage covered bond asset liability risks.
Minimum collateralisation is set at 105% and covered bond issuance is limited to 8% of an issuer’s total assets. Liquid assets used as substitution assets are also limited to 10% of cover pools. Cover assets will remain on an issuer’s balance sheet and be recorded in a register.
Banks and other financial institutions with sound financial positions can issue covered bonds, which will ensure “issuers are of high credit standing”, Moody’s said. The act permits only financial institutions with equity capital of at least W100bn and a BIS capital ratio greater than 10%.
Asset eligibility criteria are set to a high standard, with mortgage loans subject to a maximum 70% loan-to-value ratio alongside certain debt-to-income ratio restrictions.
“We expect the law to be conducive to the supply of fixed rate mortgages, which would be positive to Korea’s management of high household debt,” said Moody’s. Local banks are obliged by their regulator to raise the proportion of fixed rate amortising mortgages to 30% of their mortgage loan books by the end of 2016 from a national average of 17.3% last June.