Covered Bonds: What's All The Fuss About?

In November 2011, after intense lobbying by the banks, the Australian Government announced they had amended regulations to allow the Australian banks to issue covered bonds, while still ensuring the relative security or priority of deposit holders.

This announcement made its way into the financial pages and also received a small amount of media coverage. Peter Fullerton, Senior Credit Analyst from Schroder Investment Management lifts the bonnet to see what all the fuss is about and outlines his findings below.

A covered bond is a bond secured by a specific pool of mortgages and this essentially gives holders a ticket near the front of the queue behind depositors, if the bank was to be placed into administration. The Australian banks have been keen to issue covered bonds for two key reasons.

1.   Firstly, they are a cheaper form of funding for the banks, and

2.   They improve the diversity of wholesale funding options for the banks.

Being allowed to issue covered bonds was considered an important development to enhance Australian banks’ ability to raise funds in domestic and offshore wholesale funding markets. The banks are more than happy to give investors a senior secured position in the capital structure as there is no cost to the issuer in providing this security.

As the Australian banks deal with the inherent challenges of funding 30 year mortgages with wholesale funding issued for periods of 3-7 years average term, anything that made more funds available at a lower cost seemed like manna from heaven for the banks.

But it hasn’t quite worked out the way the banks had hoped. Why? Let’s travel over to the largest covered bond market in the world, Europe.

A whole new investor base for the banks

For many decades covered bonds have been a major source of funding for European banks and a well understood segment of the market.

The theory goes that if you have a wide range of debt funding instruments you can issue to a wide base of investors, your debt funding requirements should be more attainable. Government or sovereign debt is no longer seen as the safe haven it once was.

As a result, investors have turned to AAA rated covered bonds despite the fact that the European banks are some of the largest holders of problematic peripheral European sovereign debt. Importantly, covered bonds are predominantly issued by the segments of European banks that just fund residential mortgages and issue covered bonds to fund these operations. Investors figure that having security over residential property is a pretty safe place to be in the current market, effectively quarantining away exposure to the sovereign debt issues.

Australian Covered Bonds don’t carry the same benefits

Australian banks use a Bank Special Purpose Vehicle structure with the collateral pool remaining on balance sheet. Let’s translate that into plain English.

Different divisions within a bank usually operate under the one entity which issues all types of debt funding, including covered bonds. So, coupons on the covered bonds are paid out of the same consolidated earnings streams as other debt instruments. Should a bank go into administration or liquidation, the benefit of the pool of assets, carved out for covered bond holders, distinguishes covered bond holders from senior unsecured bond holders.

So, Australian covered bond holders essentially have exposure to the broader operations and assets of the bank including the diversification benefit this may bring.

However, it also exposes them to the broader risks of the bank’s operations. The other issue is that the Australian banks are predominantly providers of mortgage loans and their “riskier” activities are a significantly smaller component of overall operations when compared to many offshore banks.

So why would investors take a materially lower return or spread?

It’s pretty clear Europeans prefer their own covered bonds over Australian covered bonds. One reason is that European regulators give banks and insurance companies more “brownie points” (technically known as risk weighting) for European covered bonds when assessing their capital reserves.

Further, there is a perception amongst offshore investors that the Australian property market is over-valued and ready for a major correction.

Initially covered bonds haven’t been “cheap” funding

Rewind back to mid November 2011 when Federal Treasurer Wayne Swan was quoted saying “legislation the Government passed last month would strengthen the local financial system, increase the supply of credit and provide cheaper, more stable and longer term funding” as reported in the Sydney Morning Herald ( Malcolm Maiden 17 November 2011).

He was right on most counts, but only partly correct about providing cheaper funding. The point with banks is once they get hooked on the wholesale funding market they have to keep issuing to just replace the bonds that mature each month and potentially issue more to fund loan growth.

As a broad rule of thumb, each of the four major domestic banks in Australia would need to issue around A $2bn per month. It’s pretty risky for a bank treasurer to hold back issuance if funding costs or spreads blow out in a short period of time. Instead the banks tend to press ahead and issue at the market rates and hope they can pass on the higher costs.

So in conclusion, covered bonds haven’t exactly provided the same benefit to the Australian banks as 3-D films have done to support the film industry. In the longer term, when the Europeans work out some kind of solution to the sovereign debt problems and bank funding costs return to more normal levels we expect covered bonds will become a major source of funding for the Australian banks.

APRA has already identified this and will limit the Aussie banks to ensure covered bond issuance remains below 8% of total Australian bank assets.

Financial Keys will continue to monitor this investment space and provide appropriate feedback when required.