Covered Bonds

RBC has issued covered bonds – denominated in Euros.

Covered bonds are a financing that offers increased protection to the lender and decreased funding costs for the issuer. The issuer sets up a mortgage pool and securitizes it – so far, this is just an ABS. However, there is full recourse to the issuer in the event that the pool does not cover repayment of the debt. The high regard with which covered bonds’ credit quality is held is reflected in their Basel II risk-weights – there are a number of different options for the calculation, but basically, covered bond holdings are added to risk weighted assets at between 40%-50% of the charge that would be incurred by holding the issuing bank’s senior unsecured debt.

I am advised that RBC was able to sell their issue for “midswaps + 11bp” (a measure with which I am not very familiar), a rate that will can be swapped back into Canadian at Canadas + 65bp for their five year paper. This compares to GoC +88bp for CIBC’s recent five-year deposit note issue.

So, based on the Canadian Curve, and allowing a few bp for the credit differential between CIBC and RBC, 5-year covered bonds can be issued 20bp through deposit notes! This is cheap financing!

These issues have recently been authorized for Canadian Banks, to a limit of 4% of total assets after consideration by the OSFI:

We note that covered bonds — debt obligations issued by a deposit taking institution (DTI) and secured by assets of the DTI or of any of its subsidiaries — provide a number of benefits but also raise concerns. For example, covered bonds can improve funding diversification and lower costs. However, they also create a preferred class of depositors, reducing the residual level of assets available to be used to repay unsecured depositors (including the Canada Deposit Insurance Corporation) or other creditors in the event of insolvency, depending on the amount issued and the nature of credit enhancements.

RBC’s issue has been rated AAA by DBRS:

The rating is based on several factors. First, the Covered Bonds are senior unsecured direct obligations of Royal Bank of Canada (RBC), which is the largest bank in Canada and rated AA and R-1 (high) by DBRS. Second, in addition to a general recourse to RBC’s assets, the Covered Bonds are supported by a diversified collateral pool of first-lien prime conventional residential mortgages in Canada. Third, the Covered Bonds benefit from several structural features, such as a reserve fund, when applicable, and a minimum rating requirement for swap counterparties, servicer and cash manager. Fourth, the underlying collateral originated by RBC is of a high credit quality with a low credit loss historically. And, lastly, the final maturity date on the Covered Bonds can be extended for an additional 12 months, if required, which increases the likelihood the Covered Bonds can be fully repaid.

Despite the above strengths, the Covered Bonds have the following challenges. First, a weakened housing market in Canada could result in higher losses and lower recovery rates than those used for credit enhancement determinations. This is mitigated by the home equity available and conservative underlying asset values. Secondly, RBC may be required to add mortgages to maintain the collateral pool, incurring substitution and potentially credit-deterioration risk. These risks are mitigated by the ongoing monitoring of the pledged assets to ensure the over-collateralization available is commensurate with the AAA-rating assigned. Third, there is a liquidity gap between the scheduled payment of the Covered Bonds and the repayment of underlying mortgage loans over time. This risk is mitigated by the over-collateralized collateral pool and the build-up of a reserve fund if RBC’s rating falls below A (high) or R-1 (middle) and the extendible maturity date for an additional 12 months, if required. And lastly, there is no specific covered bond legislative framework in Canada, unlike in many European countries. This is mitigated by the contractual obligations of the transaction parties, supported by the opinions provided by legal counsel to RBC and a generally creditor-friendly legal environment in Canada.

A Fact Book regarding covered bonds is available from the European Covered Bond Council.

Update: OK, got it. The “midswaps” stuff bothered me because RBC seems so proud of themselves for being to issue 11bp over. Top-Quality banks ARE the interest-rate-swaps rate … bank debt should normally trade AT the swaps rate (except for weak banks, which would trade over); covered debt should therefore trade THROUGH swaps.

I have been advised that due to the credit crunch, market impact costs (or “new issue concession” to be more particular) are such that being able to issue EUR 2-billion at only 11bp over is, indeed, something of an achievement.

Update, 2012-12-21: CMHC has released the Canadian Registered Covered Bond Programs Guide.

5 Responses to “Covered Bonds”

  1. […] This could be important to Canadian investors, because there’s quite a bit of securitization done by Canadian banks via QSPEs – for instance, the Royal Bank 2007 Annual Report discloses $25-billion in securitized assets (page 82 of the PDF) which could, potentially, be affected by this change (they may reappear on the balance sheet, to be considered equivalent to covered bonds). […]

  2. […] I will confess that I don’t know whether such issuance will count against their limit on covered bonds. It might; it might not. But at any rate, the OSFI advisory seems to specifically target the […]

  3. […] Deposit Insurance Corporation has issued a press release announcing their formal approval of covered bonds: On April 23, 2008, the FDIC published an Interim Final Covered Bond Policy Statement and requested […]

  4. […] lack of specific legislation has been referred to as a risk factor for buyers of Canadian originated covered bonds, most recently in the DBRS assessment of the new […]

  5. […] wrote a very brief primer on covered bonds a while ago. The proposed and defeated federal budget promised covered bond legislation, but so did […]

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