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Exploring growth in the non-euro covered bond market

By Bill Thornhill
02 Oct 2018

The vibrancy of the sterling covered bond market this year is beyond doubt, after 21 deals from 17 issuers. UK issuers have accounted for just over half of 2018’s supply, with the remainder made up from a dozen overseas borrowers, a large proportion of which include Canadian and German names.

Supply has been boosted by domestic issuers looking to smooth liability concentrations caused by the end of the Bank of England’s Term Funding Scheme. At the same time, the relative value of sterling covered bonds has improved against the sovereign, supranational and agency sector, causing a leap in demand.

The cost of funding in sterling is seemingly prohibitive for German Pfandbrief issuers, compared to what they can raise in euros. However, once the effects of hedge accounting, currency mismatches and capital charges on cross-currency swaps are taken into account, sterling becomes attractive.

The UK market offers overseas issuers a good opportunity to sell to a largely diversified set of investors. But in addition, a range of overseas investors are also getting involved, providing a historically unparalleled depth to demand. The market has also spawned the first Libor alternatives in the form of a series of Sonia-linked trades. These have helped inspire confidence and should act as a spur for similar issuance before the December 2021 deadline when Libor will be phased out. Execution times for such trades have fallen considerably, giving issuers the conviction to press ahead with longer and potentially more challenging deals. By contrast, the dollar covered bond market has been relatively inactive so far this year. But with the European Central Bank set to step away from the euro market, there are high hopes that the relative cost of funding will improve, catalysing supply. A home grown US market, populated by a wide range of domestic issuers, still seems a distant prospect given the US administration’s apparent reluctance to reform the agency market — but hope springs eternal.

Issuers have also been working hard to tap alternative seams of demand, such as the green and sustainable markets, which are expected to prove a constant, emergent theme. Issuers, lead managers and investors gathered in Munich in September to discuss the outlook for covered bonds in non-euro currencies. 

Participants in the roundtable were:

Jürgen Klebe, senior director of funding and investor relations, Deutsche Hypo

Krishan Hirani, head of secured funding, Nationwide Building Society

Mark Hughes, head of US portfolio management, TD Bank

Patrick Steeg, head of asset liability management, LBBW

Sameer Rehman, director of syndicate, TD Securities

Wojtek Niebrzydowski, head of global term funding and capital, CIBC

Bill Thornhill, moderator, GlobalCapital

GlobalCapital: What’s driving the pick-up in sterling supply and demand this year? Is it simply a function of the rise in covered bond redemptions that issuers have refinanced with new deals?

Sameer Rehman, TD Securities: There is a strong correlation, in terms of investor behaviour and timing, which is related to redemption profiles. But that only reflects a steady state of the market. What we’ve actually seen is quite a large volume of growth in both the demand and supply dynamics. The end of the Term Funding Scheme has helped drive domestic supply with Lloyds and Santander, for example, coming to market multiple times. This is a driving factor from the home base and has also encouraged issuers from other jurisdictions to enter the market.

GlobalCapital: How have sterling covered bonds helped Nationwide transition off the TFS?

Krishan Hirani, Nationwide Building Society: It’s been six months since the closure of TFS which, as Sameer says, has caused a pick-up in issuance that’s typically very much redemption driven.

From a UK issuer’s point of view, given the nature of the product in terms of currency and asset class, sterling covered bonds are the cheapest-to-deliver funding tool available and a natural replacement for TFS.

GlobalCapital: Apart from the volume increase, how has the market evolved this year?

Hirani, Nationwide: One of the key attributes of the market this year has been maturity extension.

In the past three to five years we’ve typically seen this market being a three year market, but this year, we’re seeing the emergence of five year transactions and I think TFS has been a factor driving that. TFS, being four year funding, is now in the two to three year maturity buckets and issuers who are conscious of maturity concentration and refinancing risk will have a preference to issue longer.

GlobalCapital: Which makes the three year less useful at this point?

Hirani, Nationwide: It does if you’re concerned about maturity concentration. Banks and building societies want to avoid that concentration around 2021, which has led issuers to look further down the curve. And the fact investors are actually playing on that by buying five year trades has been particularly pleasing.

GlobalCapital: What has been driving investor interest in sterling covered bonds?

Rehman, TD Securities: The spread between SSAs and covered bonds has played an important role, in terms of driving the dynamic shift in investors’ behaviour this year. I know this is something that Mark looks at quite heavily. We’ve seen a shift in the supply side dynamics from supranational and sovereign issuers as well. The UK Debt Management Office has drastically reduced its Gilt issuance this year and over the last two years the European Investment Bank has raised less sterling than in previous years. As a result we’ve seen a tightening in asset swap levels and against Libor which has moved from flat to negative in the short end.

Mark Hughes, TD Bank: And, if you take a look at the big picture, we’re still in a world where we have fairly flat credit curves across the spectrum and rates that are still low globally. Everyone has been pretty concerned by the back-up in US rates, but even so, 10 year Treasurys are still hovering around 3%. So we’re still basically in a flat credit curve and rates environment. There’s still a lot of cash in the system which means there’s trillions of dollars that need to be put to work.

The supply-demand dynamic is a bit of a chicken and egg scenario in some respects. If borrowers don’t want to issue, buyers aren’t willing to spend the time looking. But if there are opportunities then buyers may be willing to look beyond their core investments and consider other ideas. That starts to build on itself generating more momentum.

Rehman, TD Securities: That’s right, it starts with the first deal, which has to have buyers. If that goes painfully, folks on the other side of the table aren’t going to look at the second deal because they’re now explaining to senior management what just happened. But if its goes well momentum starts to build as more buyers join with bigger order sizes.

GlobalCapital: So, lower SSA and Gilt supply has helped drive spreads tighter pushing demand into covered bonds. And this is being met with higher supply from domestic banks looking to refinance their TFS portfolios and a step-up in supply from overseas issuers?

Rehman, TD Securities: Yes, and from the supply standpoint the German issuers have quite nicely filled that void as they’ve looked to fund their growing UK commercial loan books. LBBW successfully raised an impressive amount in sterling covered bonds giving it access to a very different type of investor base than what was otherwise available.

GlobalCapital: Patrick, maybe you could tell us a little about the factors behind LBBW’s decision to issue a €750m three year debut sterling Pfandbrief in May this year?

Patrick Steeg, LBBW: We were looking at the sterling market for a while and honestly, at the beginning, compared to euro covered bonds it’s expensive. We printed the first Pfandbrief of the year, a €1bn seven year at 20bp through mid-swaps and compared to that, sterling spreads appeared too high to us. So when we took a deeper look, in terms of the effects on hedge accounting, currency mismatches in the collateral pool, and in terms of the RWA consumption of the cross-currency swap, we came to a different conclusion. We put a price tag on each of those factors and in the end it made sense.

So there was no pressure from the rating agencies because it economically made sense. We convinced our senior management’s asset liability committee to go out with the trade, even though it paid the equivalent of something like 15bp over euros.

We were extremely overwhelmed with the success of the trade which attracted £1.4bn orders from about 50 accounts, and with almost no cannibalisation from other currencies.

GlobalCapital: So you didn’t see too many euro investors cross into sterling for the extra pick-up?

Steeg, LBBW: Selectively one or two, but they hardly appeared in our euro deals, so most of the demand was completely new.

GlobalCapital: Because, given the pricing differential, you would have thought that would have been an obvious one for those guys. I think something like 40% was placed outside the UK.

Steeg, LBBW: In fact that was one of my fears as well. After we opened the books, we saw orders from the usual suspects we see in our euro covered bonds who were saying ‘thanks for the 15bp’. But their allocations were cut and instead bonds were placed with a good chunk of overseas investors such as central banks, especially those from eastern European. But, even if there had been more cannibalisation, the deal would have still made sense from an ALM perspective and from an investor relations point of view because it would have still attracted new pockets of demand.

GlobalCapital: Juergen, can you tell me why Deutsche Hypo decided to tap the sterling market?

Jürgen Klebe, Deutsche Hypo: We have a UK branch in London that is really performing, despite Brexit. We had a similar discussion as Patrick and found it was crucial to get funding in the same currency. Bearing in mind the distortive impact of the ECB’s purchase programme, sterling covered bond funding, frankly speaking, does not work at corresponding Euribor funding levels. But in our case we really wanted to avoid the currency mismatch inside the cover pool, which is something rating agencies take into account. In our case Moody’s recognised that the sterling assets were being perfectly matched within the pool, which helped reduce the collateral requirement. If you are able to account for that improvement in terms of pricing, you close the funding gap between euros and sterling.

GlobalCapital: It seems rating was more Deutsche Hypo’s focus than for LBBW, where it was more about accounting for risk weighted assets where I assume IFRS9, hedge accounting played a role?

Steeg, LBBW: It plays a role if you are unable to naturally hedge your assets and liabilities in the same currency, so yes it’s absolutely a factor.

Klebe, Deutsche Hypo: IFRS9 is key when you have a 100% swapping strategy and, though a German bank could technically fund its portfolio synthetically via swaps, it was more important in our case to link the sterling assets and liabilities together for what we consider to be our prime product, which is of course the Pfandbrief.

GlobalCapital: CIBC doesn’t have the same property lending business model as the Pfandbrief banks, so I suppose its motivation for issuing sterling covered bonds is slightly different?

Wojtek Niebrzydowski, CIBC: That is correct. We’ve been issuing over a number of years in up to five currencies from our global covered bond programme. Cross-currency, IFRS and hedge accounting are issues that we had to deal with some time ago and we are very comfortable with these concepts. We do have some sterling needs based on our capital markets and corporate lending business in the UK, but we wouldn’t fund them through covered bonds. Our approach to the sterling market is the same as any other covered bond currency market, and that is to improve investor diversification. Our two principal markets are obviously euros and dollars, but we’ve also issued in sterling, Australian dollars and Swiss francs.

We value covered bonds, ABS and senior in other currencies in relation to its cost versus domestic senior unsecured. In covered bonds we are willing to pay a premium of mid-to high single digits vis-à-vis the best alternative at that time. That’s a conscious decision to maintain global access to the five currencies and their underlying investors.

From the standpoint of sterling we first started issuing in January 2015 and we’ve had four benchmarks, one of which has since matured, and one sizeable tap. It’s been interesting to watch the development of sterling covered bonds this year, which was not far short of spectacular. Back in 2015-2016 we never really knew what to expect in the context of issuance. You could end up with a book in excess of £500m-£600m, or you end up printing the minimum £250m with a book of £300m-£350m.

GlobalCapital: Historically the shallowness of sterling demand has been a challenge. Notoriously there is good demand for one or two deals and when the next comes along a week later there’s nothing there. Does it worry you that receding SSA and govvie supply might come back hitting demand for sterling covered bonds?

Rehman, TD Securities: You certainly have to keep the historical perspective in mind but we’re at a point right now where the technicals are favourable, not just from a supply reduction standpoint, but from a cross-currency basis perspective. Some of that basis saving has been passed on to borrowers and some has been passed to investors, who’ve been able to take a higher floating margin. And that’s a function of moving away from some of the extraordinary liquidity measures that had previously impacted the cross-currency swap market.

Having a greater breadth of sterling issuers has brought along with it a deeper pool of investors, which means the market is less reliant on a select group of UK real money investors that could, frankly, make or break a deal in the past depending on their RV views and cash balances on the day. Sterling covered bonds enjoy more diversified appeal partly because bank treasuries have become more flexible in terms of what tenors, names and formats they can buy. Having said that, there are historical lessons that we need to acknowledge in terms of where the market has come from.

Hughes, TD Bank: You have a whole bunch of participants who are coming to the same point from various different angles and that’s what makes a market. Collectively, you find a clearing point and that’s when everyone looks around and goes, ‘right I’ll go live with this’.

GlobalCapital: What drives your decision to get involved in a market like sterling covered bonds?

Hughes, TD Bank: We’ll consider the likely size. If $100m of an asset class is going to become available, it’s maybe worth putting the time and effort in from an organisational standpoint to get comfortable with the credit. But when you see there’s a longer term opportunity to invest one, two or potentially three billion there’s a much bigger incentive to get involved.

Rehman, TD Securities: We often see European bank treasuries looking to get involved — be it in sterling, dollars or any foreign currency covered bond issue — provided the transaction meets the €500m equivalent threshold required for LCR purposes. If you can’t get to that minimum size, you can’t access these investors.

GlobalCapital: Krishan, can you tell us a little about how the cross-currency basis swap is taken into account when it comes to issuing covered bonds?

Hirani, Nationwide: We have the capacity to issue in a number of currencies, but we would always swap back to sterling. But all else being equal, sterling tends to be the cheapest to deliver funding as there’s no need to worry about the basis swap. The euro market is of course much deeper in terms of the investor base, the granularity of accounts and the diversification it offers away from sterling.

The cross-currency basis, when considering euros, or any other non-sterling currency, is very important when considering which market to issue in. Not only do you need to consider the basis, there is also the contingent liquidity aspect when transacting structured swaps for products such as covered bonds.

GlobalCapital: How do you view euro investors coming into your sterling deals given that, presumably, they don’t offer too much diversification?

Hirani, Nationwide: It’s all positive regardless of who those investors are. The fact we’re seeing diversification of investor type as well as geography is welcome. For example we had 15% non-UK in our last sterling covered bond which is great to see. Ten percent to 15% might seem small but it can make the difference between a £750m trade and £1bn trade or pricing at 20bp versus 18bp, it’s materially additive.

Niebrzydowski, CIBC: If I may just pick-up on one point. As a UK issuer your paper is eligible for repo with the Bank of England, I don’t think anyone else around the table has that ability. That means our reliance has to be much more on investors other than UK bank treasuries. The key names that I’m sure you see in your books would probably be largely absent from ours on account of the lack of Bank of England repo eligibility.

Hirani, Nationwide: That’s true but we had the Basel news earlier this year where they recognised covered bonds as being a product worthy of 10% risk weighting and with that there is talk of global regulatory equivalence for covered bonds.
So, despite Brexit, it’s not inconceivable that you get to a point where the Bank of England extends repo eligibility to non-UK banks.
It would be encouraging to see the Bank of England look at equivalence across the board, even if the UK leaves Europe and is not a member of the EEA, as that would encourage the sort of cross-border issuance and demand that we’ve started to see picking up in the last 12 months. Though, should we not be a member of the EEA come March next year the expectation is that we will drop from a level 1B LCR asset to a level 2A.

Niebrzydowski, CIBC: Welcome to our world!

Hirani, Nationwide: Yes we’ll be joining the table quietly over there and I think there’s an element of that which is already priced into UK covered bonds to be fair.

GlobalCapital: How does the Canadian central bank treat covered bond repo eligibility?

Niebrzydowski, CIBC: To the best of my knowledge any Canadian dollar denominated covered bond issued by a Canadian bank under legislative framework is repo eligible. Non-Canadian issues would also be eligible but under the corporate bond category — as opposed to explicit covered bonds category — provided they’re denominated in Canadian dollars.


GlobalCapital: When it comes to the progress of the sterling FIG market, we’ve recently seen another important milestone, the introduction of Sonia-linked securities. How do you think that development will be viewed by international investors and issuers?

Rehman, TD Securities: The European Investment Bank, Lloyds and Santander UK have taken out a combined £2.75bn of volume, which inspires a lot of confidence to anyone monitoring the market. It’s important to have an effective plan in place for a post Libor-world. The UK is fortunate to have had a relatively liquid Sonia derivative market for a number of years, which gives an early running start when it comes to issuing and buying Sonia-based FRNs.

GlobalCapital: Was there any logic to the order these deals came?

Rehman, TD Securities: The EIB took the first step. They’re often perceived as the Gilt alternative and are the largest supranational issuer in sterling. So, by virtue of that, they enjoy wide sponsorship amongst sterling investors. Even so, it was a lengthy process getting that deal structured, documented, priced and settled. The second phase involved monitoring its progress in the secondary market to assess how the bonds trade. We were fortunate to have several weeks of data, which showed that it traded much as you would have expected from a standard FRN.
We tried to remove reasons for investors to not get on board and reduce the time it takes for them to embrace what will ultimately become the replacement fixing. The market will continue to evolve and we may be looking at something in a slightly altered form post-2021, but we’re certainly in the right stage of development for that today.

Hughes, TD Bank: It’s great that we’re sitting here in 2018 and there have actually been deals that have priced. If we sat here a year ago I think there could have been a reasonable expectation that people would have said 2021 will get pushed back to 2023, but it’s actually developing quicker than a lot of us may have anticipated a year and a half ago. And in the US you’ve had SOFR-linked deals, so it seems everyone is getting the message that Libor is really going to go away, which means we can’t necessarily play the long game and hope for somebody to change their mind.
The fact you’ve seen these deals being priced is spurring a lot of conversations and action plans leading people to say this is part of the market that is definitely coming — so we need to be ready for it.

Hirani, Nationwide: And the recent Sonia-linked trades have been very helpful for us in terms of identifying the core investor base and their operational capacity to invest.

GlobalCapital: What sort of challenges do you need to overcome before Nationwide would feel comfortable with issuing a Sonia-linked trade?

Hirani, Nationwide: From a programme documentation perspective, we’ve recently included Sonia language and fall backs in the terms and conditions. There is also the quite substantial task of ensuring booking systems and downstream payment systems are able to process Sonia. At Nationwide, in the last 12 months, we’ve implemented a new end-to-end treasury system, which is Sonia capable. We are just in the final process of doing a clean sweep of all of our reporting requirements to make sure we have not let anything slip through the net. This is particularly important for the UK regulated covered bond product. We expect that to be done shortly, at which point the option of issuing Sonia-linked securities will be open to us.

GlobalCapital: How are German issuers looking at these developments?

Klebe, Deutsche Hypo: We want to establish ourselves as a strategic sterling issuer meaning that we want to issue if not every year, then every second year. In March we priced our first benchmark sterling Pfandbrief and opted for the simple Libor reference rate. We had expected the major UK issuers to open the market and we’ll be closely watching developments and will prepare accordingly, but we’re not there yet.

Steeg, LBBW: We’re in a similar situation. First we would like to establish a curve and, if there’s a market we’ll find the replacement language and documentation. We definitely won’t be ignoring developments. We’ve just established our first sterling Pfandbrief and in time we would definitely like to have the option to issue Libor and Sonia. We would like to avoid having a basis mismatch where you have assets referenced against Libor and liabilities referenced to Sonia. So we would be very happy to see developments taking place on the asset side before they translate to the funding side.

GlobalCapital: How do you reckon the market will evolve from here?

Rehman, TD Securities: If you look at the lead times for Sonia-linked transactions, they’re coming down in a hurry. The EIB was months in the making, but once it was formally announced we effectively had a four day period to pricing. With Lloyds it was three days and with Santander UK it moved down to two. Albeit a money market one year instrument, Royal Bank of Canada was able to issue its senior unsecured deal intra-day. This shows that the execution risk element of these trades is winding down, as well as the product premium.
That said, there is a meaningful contingent of investors that for systems, operational, valuation or auditing reasons aren’t quite on board yet. But there isn’t a meaningful investor we’ve spoken to that isn’t already in the process of getting on board. We’ll soon come to a point where these Sonia deals will, from an execution standpoint, be equivalent to their Libor or fixed rate counterparts. 
And, in terms of where this market is set to go from here, I would love to see a non-UK based name take that next push forward.

GlobalCapital: With a five year covered bond?

Hirani, Nationwide: Yes, absolutely I see it as a natural next step. You see fewer unsecured sterling floating trades, but there is a market for that also.

GlobalCapital: What happens after the 2021 cut-off? Is everyone supposed to have suddenly gone to Sonia or can Libor continue to live?

Rehman, TD Securities: From that point banks are no longer compelled to submit Libor. That does not necessarily mean Libor won’t be there, but there will be a period of uncertainty for how long submissions will continue. There are mechanisms and existing documentation in place that show how sterling Libor can get calculated, if it fails to get done by the calculation agent for example. But the effective cut-off is the end of 2021.

GlobalCapital: Does that mean people must stop using Libor from then on, or can they continue?

Rehman, TD Securities: They can, but it will add another layer of uncertainty.

Hirani, Nationwide: We need to be ready for there to be no Libor after that date and in the UK and we’re preparing for that. That means we need to be thinking of the outstanding securities that will be maturing at the start of that period, and what happens to those when there is no Libor.

Hughes, TD Bank: I think the uncertainty will clear up over the next two, three years but sitting here today you can certainly envision a scenario where it’s potentially not an orderly change. But there again maybe it’s like Y2K, where we all woke up on New Year’s day and everything turned out fine. But I think there’s still a lot of answers that have to come out between now and then.

Dollar covered bonds

GlobalCapital: Well it certainly feels like we’ve got off to a convincing start with this first flurry of Sonia-linked deals so there are grounds for optimism. Which stands in contrast to the dollar covered bond market which, in terms of primary volume, has had one of its poorest years in a long time.
With the ECB likely to be less present there is some hope euro funding becomes less competitive and that should start to favour dollar funding. On the other hand the ECB owns 40% of the eligible universe, and if they’re going to fully reinvest that portfolio they’ll still be buying €1.5bn-€2bn a month for the next four years or so. Do you think that’s likely to be enough to tilt the balance and entice issuers back to dollars?

Rehman, TD Securities: QE has completely distorted euro pricing and it’s been exceptionally difficult to show compelling dollar pricing against that. But when it comes to the dollar covered bond market, every little helps. We are starting to see larger new issue concessions manifest in euro covered bonds and we have to be cognisant of how the cross-currency basis swap moves with respect to dollars. If we can get to a point where the break-evens make sense, demand will be there.
So it’s really just a case of testing what the threshold for paying for dollar diversification is. We’ve seen issuance in the supranational world across the curve, but you have less maturities to play with when it comes to covered bonds which in dollars is in the three to five year camp. A spread widening in the euros will definitely help.

GlobalCapital: How does LBBW view the dollar market, is that a top priority?

Steeg, LBBW: We are also quite active in the US commercial real estate market and have a branch in New York. So naturally we have to fund these dollar assets. We look at the impact that creates the mismatch in the collateral pool and the RWA consumption, if we use cross-currency swaps to fund those assets. Even so, dollar covered bond funding was not competitive this year, the German market was much more attractive. But we will definitely return.
We are currently only active in Reg S format and there’s not a lot of flexibility in terms of maturity, which is predominantly three year. It’s hard to get longer liquidity and the investor base is not as diversified as euros or sterling. But since we are notching up our operations in North America, and in dollar assets globally, we are internally discussing whether the 144A market would make sense for us.

GlobalCapital: I assume Reg S buyers are not too dissimilar to those buying your euro deals and you would get more diversification with a 144A deal?

Steeg, LBBW: Definitely. In the order books we predominantly see eastern Europe, Central Asian banks and some Nordic buyers which do have a natural need to invest in dollars.

GlobalCapital: Juergen, does Deutsche Hypo issue in dollars?

Klebe, Deutsche Hypo: We have issued, but we are stepping out of the US market, and though we still have 1%-2% dollar assets, we are shrinking that. With a balance sheet of €21bn our name recognition in the US is poor. So even if we had the ability to issue in 144A format, it’s unlikely many investors would consider our name.

GlobalCapital: Nationwide, along with the other UK issuers, use the US market for RMBS and not covered bonds, why is that?

Hirani, Nationwide: I think it’s due to the familiarity that the US investors have with the ABS market. US ABS is the biggest in the world, which means they have lots of scope to compare and do relative value calculations when assessing dollar RMBS. RMBS is the natural domestic play and that’s why we do quite regular issuance.
The lack of a home-grown US covered bond market is probably the biggest reason for their hesitancy and that potentially means you’re reliant on a small handful of large investors to support your trade. But dollar covered bonds is something Nationwide continues to monitor, along with other currencies such as Norwegian krone, Swedish krona and potentially Canadian dollar, where we have issued in private placement format.

Hughes, TD Bank: It’s all about familiarity, and here’s a way of illustrating it. The post-crisis lesson learned from investing in US non-agency RMBS was that everybody wanted loan level information and a spreadsheet with 256 fields and lines to the end of the spreadsheet, because everyone got punished for not having enough information or doing enough digging into deals.
But in the end, it’s that familiarity which is driving the US market’s greater interest in RMBS. Whether you grew up investing in covered bonds, or in RMBS, that’s what you know and understand so you’re just naturally more biased to look at one instrument over the other.

Niebrzydowski, CIBC: I’m not necessarily sure that the established covered bond investors are looking for RMBS style, SEC type of Reg AB disclosure, and we don’t believe anyone outside the US is actually capable of providing that while satisfying all their legal and regulatory commitments.

GlobalCapital: Is the RMBS investor base the same or different compared to the covered bond investor base?

Hughes, TD Bank: It’s largely the same investor base.

Rehman, TD Securities: Even though there are real structural differences between the two products, there is some element of investor overlap.

GlobalCapital: But if a UK issuer was to launch a dollar covered bond do you think that would be a natural fit next to a Canadian or Australian deal?

Hughes, TD Bank: The difference with covered bonds is that I’ve got to get comfortable with the covered bond legislation. If there’s never been one – meaning a covered bond in a currency under a specific framework — am I really going to do the work? There might only be one trade, but am I really going to tell 25 people to start doing the due diligence for something that may or may not happen? With the Canadians and Australians there’s enough issuance to justify doing that work.

GlobalCapital: There was a time, I think it was seven years ago, when Barclays and quite a few other European names were active in the US dollar market.

Niebrzydowski, CIBC: Yes HSBC was there too, along with CFF and UBS.

GlobalCapital: It was a thriving market, albeit briefly.

Niebrzydowski, CIBC:  Together with our Canadian peers we created this market in 2010 when there were predictions of $90bn-$100bn issuance a year, but ultimately it never happened.

Rehman, TD Securities: Unless we get some reform of the GSEs, or some form of covered bond legislation you won’t ever have a natural US issuer or investor base, so they’re always going to be reliant on the Canadians, Nordics and Australians to lead the way.

GlobalCapital: Can you ever see that changing?

Hughes, TD Bank: There are regulatory and legislative hurdles in establishing a US covered bond market. That’s one of the key stumbling blocks preventing a US home-grown covered market developing. It’s a fundamental point

GlobalCapital: I had a very interesting conversation with a lawyer the other day who suggested that the responsibility for social housing could be taken away from Fannie Mae and Freddie Mac and put with the Department of Housing and Urban Development. He thought that would need to happen by autumn to take it to the next level. In any case he thought that could be quite a positive starting point to consider reform of the GSEs. But since they’re currently making good profits, I doubt there’s much appetite for reform.  

Niebrzydowski, CIBC: What would be helpful, and in theory should be much easier than GSE reform, is Federal Reserve eligibility.
My German colleagues here are fortunate to have had that for a number of years, but no one else does. That would definitely facilitate more demand from US bank liquidity portfolios.

GlobalCapital: But the Canadian issuers don’t really seem to have any problem accessing the dollar market. Is that because of their better brand recognition relative to UK names?

CIBC, Niebrzydowski: Yes, along with Nordic and Australian names, based on what we’ve been seeing from issuance. And, as has been discussed in the context of sterling market, it’s a chicken and egg situation. There needs to be more issuance for the investor market to develop. The more supply, the more investors will come.
Though, for the last year or two, the lack of supply has been more because of poor relative value. We were willing to pay one or two basis points for diversification in our $1.75bn three year issued in June and I wish there had been a few more Canadians that followed through after us.

GlobalCapital: How helpful has Canadian government been in supporting the issuer base with respect to Canada’s covered bond law?

Niebrzydowski, CIBC: The legal framework was introduced by parliament through the Department of Finance in 2012. At that time our principal issuance was US dollars and, to a lesser degree, Australian dollars. Our friendly Canadian competitors were also very active in US dollars. At that time I did not get the feeling that the legal framework, versus lack thereof, would make any meaningful difference for us in the US.
But we, as an industry, did feel strongly that it was needed by the Canadian banks when it came to selling bonds in the European market. There was, however, no Canadian issuance in euros between October 2008 and July 2013, principally because the cross-currency swap was unfavourable, and the cost of euro funding didn’t make sense. But, from the standpoint of the need for a legal framework, we realised that it was something that we needed to work on as far back as 2008.
It took us four years to get there, and now it’s just a given that of course Canada has a legal framework. In the context of LCR eligibility, bonds need to be issued under a national legal framework so obviously we met that criteria. However, we still don’t meet the CRR criteria which says you need to be a European based issuer to be eligible for inclusion in level 1B of the LCR.

GlobalCapital: Hopefully the Basel Committee on Banking Supervision’s recognition of covered bonds and recommended introduction of a global preferential risk weight will help change that?

Niebrzydowski, CIBC: It was definitely very helpful and it was the right thing to do, but I don’t expect it will implemented for a few years from now.

GlobalCapital: Do you think there’s room for more flexibility on Canada’s cap, which limits the volume of covered bonds per institution to 4% of the value of assets on its balance sheet? In April we heard the superintendent at OSFI, saying Canada was taking ‘a hard look’ at that limit in the context of banks’ overall asset encumbrance. We’d been promised a proposal this year and there are still three months to go.

Niebrzydowski, CIBC: The industry has periodically been trying to get a solution to this issue since 2009. We managed to get the legal framework in place, but we’re still looking at the 4% limit. Let’s see what happens in terms of developments.

Rehman, TD Securities: We can safely say that, given the maturity profile adopted when Canadian banks first started issuing under the new legislative framework, we at least have a redemption profile that’s running at a steady rate, in the absence of any increases to the cap.

Green covered bonds

GlobalCapital: In the absence of change in that cap, issuers can be expected to continue to identify and leverage new pockets of demand, such as that offered by green covered bonds. Deutsche Hypo recently issued a tightly priced green Pfandbrief, its second I believe. Juergen could you talk to us about your bank’s motivation to embark on this project?

Klebe, Deutsche Hypo: It was our second Pfandbrief following our inaugural deal issued in November 2017. Both were €500m no-grow six year deals, but that same choice of tenor was really by chance. With both the first and the second deal we managed to tap into a new community of investors, ones which we had not ever met until the roadshows. So that really helped us to diversify our name with new investors.
We originate green commercial real estate loans and ‘repackage’ them into the Pfandbrief. These investors are dedicated to the green concept and are keen to see more green supply. With the second green Pfandbrief we managed to secure some large orders at the start of the bookbuild, really helping to drive momentum, which is quite unusual. All too often you have these trend followers in the order book who generally don’t place their order until the end of the process. We feel that both transactions went very smoothly.

GlobalCapital:  LBBW issued its inaugural green Pfandbrief this year and it also went very well. Was your motivation similar to Juergen’s? It seems like this is a market that’s is going to grow slowly but consistently as climate change is coming whether we like it or not.

Steeg, LBBW: We issued our first green deal last year in senior unsecured non-preferred format, but our primary motivation was not for the investor diversification it would offer. We were motivated by more of a strategic angle. Sustainability plays an extremely important role at LBBW.
Whether it is on the corporate side or real estate, sustainability plays an important role. The biggest part of our real estate portfolio is energy efficient mortgages and on the project finance side we’ve started to finance renewable energy. Our framework currently includes energy efficient real estate and renewable energy. We are also currently in the process of structuring a social bond programme.
Diversification is always a goal which is applied across several funding instruments. But during the green structuring phase we really went through the whole value chain from front to back, which means sustainability is much more in the forethought of our minds at LBBW. The deals were both priced more or less at the same spread as vanilla deals. However, when it came to the secondary market we observed spreads were much more stable over time which I think augurs well for the development of the market.
You have also these traditional buyers, as well as a lot of new buyers. I was really surprised to see one or the other name, which I hadn’t previously known about. So there is diversification that comes with this type of issuance.

Klebe, Deutsche Hypo: Looking at a green order book, you are often not really familiar with some of the buyers, though their name usually hints that they’re a green investor. From the point of view of society, the green idea is becoming increasingly relevant. Even if politicians neglects to push the green agenda, the need to reduce CO2 will always remain. We opted to secure our deals on green commercial real estate loans, partly because it’s more straightforward to define criteria on these assets, measure the implied CO2 reduction, and explain this to our investors.

GlobalCapital: Has Nationwide embarked on green issuance?

Nationwide, Hirani:  Yes. Green developments and, in particular, social responsibility absolutely tie in with our values, principles and beliefs as a mutual building society, not a bank. We are in the process of formulating a social framework, which we hope to have published next year, and which will allow us to issue going forward.

GlobalCapital:What instruments do you think you’ll be issuing?

Hirani, Nationwide: I find no reason why it can’t be any of our funding tools, be it senior unsecured or covered bonds.

GlobalCapital: Wojtek, how are you looking at the green market these days?

Niebrzydowski, CIBC: Well let’s start with the social responsibility bonds. We just launched a Canadian dollar senior unsecured transaction under Women in Leadership Social Bond Framework about an hour and a half ago, the first in Canada and one that I’ve been following while I’ve been here!

GlobalCapital: Hot off the press!

Niebrzydowski, CIBC: It’s not a social chat that’s been distracting me. I’ve actually been looking at how the book has been developing. The socially responsible senior transaction was our first preference, rather than green. But that doesn’t necessarily mean we wouldn’t look at green going forwards. In terms of the form, I think that given fairly limited and strict criteria on the type of assets we can put into Canadian legislative covered bonds cover pools, we find it’s much easier to issue out of the corporate or commercial loan books — rather than try to squeeze it somehow into a residential mortgage covered bond programme.
It is, however, feasible to issue a green covered bond and ultimately we may look at something like that, but then again we face a bit of a chicken and egg dilemma. We need to be able to either have green mortgages, or anticipate having green mortgages. On the other hand we already have other assets on the balance sheet that meet the eligibility criteria of our social responsibly framework, both in terms of future origination and renewals of our existing portfolio.  

By Bill Thornhill
02 Oct 2018