Basics of the U.S. Market
Today the covered bond market in the United States is essentially a non-U.S. financial institution market. While two U.S. financial institutions (Washington Mutual and Bank of America) issued covered bonds in 2006 and 2007, since then there has been no issuance by domestic banks. This is due in part to the lack of a statute in the U.S. enabling U.S. institutions to issue covered bonds. (See U.S. Legislation).
Since 2010, however, non-U.S. banks have with increasing frequency come to the U.S. to offer their covered bonds. Today this is a $160 billion market in the U.S., still small compared to Europe, but growing quickly. The market has had some very attractive pricing. For example, in late 2011 Toronto-Dominion Bank issued a $2 billion 3 year at mid-swaps +44 and a $3 billion 5 year at mid-swaps +26. In a different market in September 2012, Royal Bank of Canada issued the first SEC registered covered bond, a $2.5 billion due 2017, at mid-swaps +35. And in offerings that extended the maturity curve, SpareBank issued a $1.0 billion 7 year at mid-swaps +75 and ING Bank issued a $1.5 billion 10 year at mid-swaps +98, both in November 2012. In July 2015, new entrant, DBS Bank Ltd of Singapore, issued its first-ever covered bond, a $1 billion offering that priced at mid-swaps +37.
What are Covered Bonds
A covered bond is a senior obligation of the issuing financial institution that is secured, or guaranteed by a guarantee that is secured, by a cover pool of high quality assets. (See What Are Covered Bonds?) The most common assets are residential mortgage loans, but depending on the issuer’s jurisdiction may also include commercial mortgage loans, public sector obligations and ship mortgage loans.The unique feature of a covered bond is that if the issuer becomes insolvent, the bond is not accelerated and the assets in the cover pool are segregated from the other assets of the issuer and administered exclusively to pay the outstanding covered bonds as scheduled through their scheduled maturity date.
Covered bonds are viewed as very low risk by investors because of the dual recourse provisions of the instrument. Generally, covered bonds are purchased by the same investors that buy sovereign debt or agency debt. The risk is viewed as similar, the yield is better. During the euro crisis, in some jurisdictions, covered bonds of domestic issuers priced better than local sovereign debt as they were seen as less risky.
Why Issue Covered Bonds
Covered bond investors typically do not purchase RMBS, ABS or corporate debt. Accordingly, the only access to this investor base for financial institution issuers is through covered bonds. The benefit is two-fold. First, it provides important diversification to the investor base and, second, the cost of funding tends to be lower than any other funding source available to the institution with the exception perhaps of its central bank.
The indirect cost, however, should not be ignored. The assets in the cover pool remain on the balance sheet of the issuing institution. That means the institution must allocate capital to the assets and bear 100% of the risk of loss on the assets. This creates a strong incentive to use high quality assets in the cover pool.
U.S. History of Covered Bonds
Washington Mutual issued the first covered bond by a North American financial institution in September 2006 in an offering that was 4 times oversubscribed by European investors. This was followed in early 2007 by an offering from Bank of America. Due to regulatory and legal constraints and the lack of an enabling statute, these offerings utilized a costly and complex structure that is not usable in today’s environment. No U.S. financial institution has issued covered bonds since 2007.
However, non-U.S. issuers have found the U.S. market attractive because it has provided important investor diversification. Offerings in the U.S. market to date have been in U.S. dollars. The viability of the market depends on the currency swap rates for swapping U.S. dollar proceeds into an issuer’s domestic currency. In 2011, 2012 and part of 2013, the swap rates were very favorable for U.S. dollar issuance. In late 2013 and 2014, swap rates favored issuance in Europe in euros. Currently cross currency swap rates are closer to neutral.
European History of Covered Bonds
The history of the European covered bond market is dealt with in detail elsewhere. See, e.g., the ECBC and Pfandbrief links on the Useful Links page. The market provides the primary source for financing residential mortgage loans in Europe where no counterparts to Fannie Mae and Freddie Mac exist. Current outstandings in the market exceed euro 3 trillion with maturities out to 15 years and in a few cases out to 50 years. The market mostly continued to function throughout the financial crisis, providing important liquidity in a troubled world. Covered bonds are favored in Europe today because they avoid the “bail-in” risk that faces senior bonds. They are also favored by regulators as an investment for banks. Under current capital requirements, a “AAA” covered bond would attract no more than half the capital of senior debt from the same issuer.
Primarily a 144A Market
Until the RBC offering in September 2012, all of the offerings of covered bonds in the U.S. market had been 144A offerings. The advantage of 144A offerings is that the issuer does not have to have discussions with U.S. regulators and can move quickly to market. The disadvantage to 144A offerings is that the securities are “restricted” securities and many investors have a limited capacity to purchase restricted securities. These limitations affect pricing and the secondary market.
SEC registration addresses both of these disadvantages. First, SEC registered securities are not “restricted” securities and, therefore, investors are not restricted in their ability to buy them. This brings more investors into the market and improves the secondary market. Additionally, SEC registered securities are eligible for the bond indices, such as the Barclays Aggregate Bond Index. This pushes index funds to purchase the bonds and provides important pricing information. Finally, SEC registered securities are eligible for the FINRA TRACE Reporting System, which will disclose pricing on every secondary market trade in the securities, providing important transparency. All of these features will improve pricing for issuers in the primary offering. RBC offered the first SEC registered covered bonds in September 2012.
Second, RBC registered its covered bonds on Form F-3, a shelf registration form. This allows RBC to register a large amount of securities that it may offer whenever market conditions are favorable. With shelf registered covered bonds, RBC can decide to issue with as little as a few hours notice.