Covered bonds are much like normal bonds except that they carry an extra level of security ‘cover’. They are generally backed both by the issuer and by a specific pool of assets. The only issuers of covered bonds Australia are the big four banks plus Suncorp-Metway. Banks have typically issued covered bonds at tenors of 5 to 10 years, compared with a norm of 3 to 5 years for their unsecured bonds.
Banks have slowed down their issuance of covered bonds now that their covered bond programmes are maturing, having only been able to issue under these programmes since late 2011. Covered bonds have allowed banks to diversify their investor base and reduce their funding risk. Australian banks’ covered bonds have consistently been rated AAA, which has allowed the banks to attract new funding from investors with AAA mandates. This could also have helped those banks repurchasing their government-guaranteed debt, as the banks were able to offer investors an alternative AAA asset to invest in.
Because the assets backing the bonds are ‘ring-fenced’, easily identifiable and stay on the issuer’s balance sheet, the bonds tend to have a higher credit rating than bonds that are not covered. The quality of the credit rating will still depend on the quality of the pool of loans providing cover for the bond. In the event of the default of an issuer, rather than relying on the winding-up of the company to retrieve their capital, bond holders also have recourse directly to the pool of assets.
From an investor’s perspective, such bonds can be attractive because they are high-quality instruments that offer attractive yields and are often more secure than relying on the credit worthiness of the issuer alone. Covered bonds usually trade at lower yields to corporate debt because of this. However, when corporate bond spreads to government bonds are narrowing, covered bonds might be expected to underperform senior debt as there is less margin to compress.
From an issuer perspective covered bonds can be a low-cost way to expand the business in preference to issuing unsecured debt instruments. The popularity of covered bonds has waned as the popularity of RMBS (Residential Mortgage Back Securities) has grown. RMBS are similar to covered bonds but differs in that RMBS are backed by a pool of mortgages only and are off-balance sheet items for the issuer. In other words, RMBS are not backed by the mortgage provider.
In a recent report, Fitch suggested that covered bond investors are likely to increase their holdings in Australia. The agency said that a larger proportion of the investors they surveyed, 24 per cent, viewed regulatory treatment as the biggest concern facing covered bonds compared to only 5 per cent last year. Based on number of respondents, regulatory treatment ranked second behind sovereign risk, and on a weighted view of the responses, second behind health of the banking sector. The uncertain impact of regulatory treatment was highlighted by mixed views on whether the Bank Recovery and Resolution Directive would increase or decrease the credit risk of covered bonds. Thirty-seven per cent of polled investors expect higher credit risk, while 36 per cent expect lower credit risk and 27 per cent expected no change.
This year has seen a growing trend for Australian corporates to issue covered bonds in Europe and take advantage of falling borrowing costs. ANZ has joined this group of issuers and sold €1.25bn worth of 10-year notes in the first week of the year to yield 36bps over Swap. The average extra yield investors demand to hold covered bonds instead of government debt has fallen 55bps in the past year to 74bps, the narrowest spread since July 2008.
This same dynamic is causing offshore covered bond investors to increase their Australian exposure. Lack of issuance from Europe and the hunt for yield is driving covered bond investors to increase their non-European covered bond investment holding, according to Fitch. Australia was placed third after Canada and the UK as countries where investors expected to increase their holdings during 2014. Fitch suggests that investors are looking to diversify more of their holdings in the APAC region and the increased interest in APAC covered bonds is reflected in the strong start to the Australian covered bond market in 2014. The first quarter saw a total of $7.3bn issued between all four major banks, up from $5.5bn in the previous quarter.
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Paul McNamara is an editor and journalist with over 20 years’ experience. His career includes spells with the Financial Times, Euromoney, BRW Media, Asia-Inc and Banker Middle East. At present he is editor of YieldReport. YieldReport is a digital newsletter that carries comprehensive pricing and commentary on Australian interest rate securities in a monthly and weekly report. Each issue covers bank bills, cash accounts, term deposits, government bonds, semi-government and corporate bonds, hybrids, ETFs, managed funds and more. Click here for a free trial subscription. |
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