The bluffers guide to covered bonds

Bluffers guide to Covered bonds

Next week the World Bank is in South Africa to discuss covered bonds with the local association of investment managers. For Uber taxi-drivers lucky enough to ferry our hard-currency, well-heeled visitors from abroad, here’s the bluffer’s guide to covered bonds. You may find it useful in striking up a conversation and earning that sought after five-star rating for your driving experience.  

The South African banking regulator’s position on covered bonds	On May 23rd 2011 the South African Reserve Bank’s (SARB) Office of the Registrar of Banks issued a guidance note banning South African banks and branches of foreign banks from issuing covered bonds or from engaging in any structured transaction that was the economic equivalent of a covered bond.   As covered bond ranks senior to uninsured depositors as well as to senior, unsecured creditors, the Bank Supervision Department (BSD) of the SARB was concerned with protecting depositors.   As South Africa does not have any scheme protecting depositors, the implications of covered bonds on the local depositor base would be different to that in, say, the UK where depositors are protected for the first £85,000 of deposits held with a single authorised bank.
The South African banking sector	Ring-fencing retail from investment banking is not on the cards and so protecting depositors will need to take another form, as in the rest of Europe, UK and the US.   According to the SARB, the four largest South African banks (often called “the Big 4”) are Domestically Systemically Important Banks (D-SIB) and the SARB is applying many G-SIB proposals to these Big Four banks. In fact the TLAC (Total Loss Absorbing Capacity) requirement to be applied to these D-SIBs has been finalised but remains confidential. South African banks   -          Are dependent on wholesale, short-term funding -          Tap into a retail deposit base that is small since most retail savings is channelled into pension, insurance and money market funds -          Tap into a larger corporate deposit base but corporate deposits are typically “haircutted” relative to retail deposits and are therefore not as favourably treated for purposes of meeting the LCR and NSFR requirements -          Have limited access to long-term funding in capital markets   SA banks have -          an LCR shortfall of c. R140bn (SARB; Guidance Note 6; 2013). The LCR of five of six South African banks tested by the IMF is below 100% but as the IMF noted, the SARB introduced a CLF (committed liquidity facility) which allowed all banks to meet the LCR. -          An NSFR of below 100% with the exception of one bank   Barclays estimates that the five largest South African banks may need to issue approximately R402bn of listed debt vs their current outstanding debt of R207bn or a total listed bank debt of R280bn.   The cost of raising this debt is likely to be penal, especially if only existing instruments are used. Covered bonds may be one way of softening the blow on the local banks however, given South Africa’s lack of a scheme protecting depositors, covered bonds could subordinate the very people that the new banking regulations are seeking to protect.   On the other hand, complying with the LCR and NSFR regulations is going to have an adverse impact on the profitability of local banks. No doubt the brunt of this pain this will ultimately be felt  on an already stretched South African consumer, many with high debt burdens.   It is therefore in the country’s interests to find a solution to this problem.
What are covered bonds?	They are senior, bullet instruments of an issuer (typically a bank) where the bond holder has recourse both to the issuer as well as an underlying collateral pool.   The bullet payment can be “hard” i.e. no possibility of extension risk or is can be “soft” with the some option for the issuer to extend the repayment date by a period, typically no more than 12 months.   Bonds can either be fixed rate or floating but the majority of issuance globally to date has been fixed rate. Hard bullets tend to dominate over soft bullets with mortgages being the overwhelmingly dominant type of collateral.
What collateral is typical?	Typically collateral types will be defined by legislation. In the UK, for example, where legislation was, for a long time, lacking then collateral types would have been defined in transaction documents   Typical collateral types -          Mortgages (residential and commercial) -          Public sector exposures -          Shipping, SME and aircraft exposures   Mortgages account for c. 80% of collateral across global covered bond market and public sector exposures c. 18%.
What risk is there to a covered bondholder?	The bondholder is exposed to the risk of the issuer (the bank) defaulting. In the event that the bank defaults, the bondholder will have recourse to ring-fenced collateral pool, the nature of which has been pre-agreed with the bank. On bank default the credit risk changes from being bank credit risk to credit risk exposure to the underlying collateral pool.   Should the collateral pool be insufficient to meet the claims of covered bondholders, then the outstanding amount becomes a claim against the issuer (the bank) and ranks pari passu with other senior, unsecured bondholders.
Why covered bonds differ from Residential Mortgage Backed Securities?	RMBS are characterised by -          A pass-through structure vs a bullet under a covered bonds -          Recourse to the collateral pool only vs covered bonds having recourse to both the issuer and the collateral pool -          Credit enhancement in the form of subordination vs covered bonds where the enhancement is typically only through over-collateralisation
What are the structural forms of covered bonds?	There are three structural forms – the first two are typically called “legislative” models and the third a “structured” model. This terminology arises because some countries did not have covered bond legislation in place and so sought to make use of existing securitisation legislation and methods to create the economic equivalent of covered bonds. Many of these countries have since created the appropriate legislation blurring the lines between “legislative” and “structured” markets.   1.       On-balance sheet Covered bond is issued from the balance sheet of an originating bank with the collateral pool remaining with the originator but ring-fenced in case of insolvency.   2.       Specialist Bank Principle The bank that wishes to access covered bond financing establishes a wholly-owned subsidiary to which it transfers the collateral pool. The subsidiary issues the covered bond which is backed by the transferred collateral pool.     3.       Structured/guarantor model Covered bonds are issued by the bank as unsecured obligations. Money raised by issuing the bonds is then lent to a limited liability SPV which then acquires the collateral pool using the loan proceeds. The SPV then guarantees the unsecured bonds and will use the collateral to pay bondholders in the event of the issuer’s insolvency.
Where might covered bonds feature in SA fixed income mandates?	Covered bonds rank right at the top of an issuing bank’s capital structure – above uninsured depositors (in the case of SA, that is all depositors!) and senior, unsecured bondholders.   In a South African context, given the D-SIB recognition by the SARB, then the credit risk related to covered bonds (should they come into existence) issued by the Big 4 banks may lie just below that of the debt of State Owned Companies   A ranking of credit risk in the SA market may look (from highest to lowest) as follows   -          South African government bonds -          Government guaranteed bonds issued by State-owned Companies -          Non-government guaranteed senior debt issued by State Owned Companies -          Covered bonds issued by Big 4 SA banks -          Senior, unsecured Big 4 bank debt -          Other bank debt/ Corporate debt / Old-style bank sub-debt / new style bank sub-debt   It is therefore very likely that fixed income managers are likely to view covered bonds somewhere between non-government guaranteed bonds issued by State Owned Companies and senior, unsecured Big 4 bank debt when looking for yield enhancement in fixed income mandates managed against both market and liability benchmarks.   Assuming that SA Big 4 banks do ultimately issue covered bonds, then depending on the level of spreads on offer, the potential danger for SOC issuers is that covered bonds may be seen to offer a more attractive risk-adjusted return that their non-government guaranteed debt especially given the D-SIB status of the Big 4 SA banks.   Certainly, in the early stages of any such market developing the natural process of price-discovery in the early days may create opportunities for those investors whose mandates are flexible enough to allow their fund managers room to invest in covered bonds.
Key market statistics globally	1.       Largest covered bond market is Germany followed by Denmark, Spain, France and Sweden. 2.       2/3rds of covered bonds are denominated in Euros. 3.       Bank in Spain and Denmark are the largest issuers of mortgage-backed covered bonds. 4.       German banks are the largest issuers of public-sector backed covered bonds.