PwC cautions banks against placing too much reliance on covered bonds saying they add 'incremental constraints'

By Gareth Vaughan

Auditing and financial services firm PwC is warning banks to be cautious in their use of covered bonds and not place too much reliance on them.

The comments come in a report by PwC entitled Uncovering covered bonds that points out last year was a record year for covered bonds, with US$405.1 billion (about NZ$505 billion) worth issued globally. On top of that, another US$153.3 billion worth were issued in the first quarter of 2012.

New Zealand's big four banks - ANZ NZ, ASB, BNZ and Westpac NZ - between them have now borrowed about NZ$9.97 billion through issuing covered bonds - mainly to European institutional investors - since BNZ became the first to do so in 2010.

The latest issue comes from ASB, with the bank pricing a €500 million (about NZ$771 million) five-year covered bond 68 basis points over the swap rate. Although cheap money for the banks, covered bonds aren't quite that cheap. The Reserve Bank recently pointed out the cost to banks of converting money raised overseas through long-term bond issues into the New Zealand dollar effectively adds another 100 basis points to their cost of borrowing.

It's ASB's first euro denominated covered bond, with the bank having previously completed two issues, worth a combined NZ$500 million, to domestic institutional investors, and a CHF200 million (about NZ$257 million) issue. All up, ASB has now borrowed a total of NZ$1.528 billion through covered bonds, equivalent to about 2.4% of its NZ$64.396 billion of total assets. The Reserve Bank says banks can use up to 10% of its total assets as collateral for covered bonds.

However, this Reserve Bank limit didn't stop ASB establishing a €7 billion (about NZ$10.8 billion) covered bond programme last year, which is almost twice the value of its NZ$6.4 billion 10% asset limit. ASB said, however, a programme of this size - with issues taking place over several years - allows for future growth in its asset base.

Kiwibank may be the next New Zealand bank to issue covered bonds. Interest.co.nz reported last month that the state owned bank has hired Britain's Barclays Capital to arrange a covered bond programme, appears to have established a covered bond trust, and could borrow about NZ$1 billion through issuing covered bonds.

Dual recourse for investors'

Covered bonds are dual-recourse securities, issued for anywhere from three to 10 years, through which bondholders have both an unsecured claim on the issuing bank (should it default on the bonds) and hold a secured interest over a specific pool of assets - generally residential mortgages - called the cover pool.

This ring fencing of a chunk of a bank’s balance sheet - being the residential mortgages written by the bank issuer placed in the cover pool - is why covered bonds were banned by the Australian Prudential Regulation Authority as, in the event of a default by the bank issuer, depositors’ claims are diluted. However, the Australian government has now passed a law allowing banks there to issue covered bonds.

Covered bonds are different to senior unsecured debt instruments issued by banks, where the bondholder is simply an unsecured creditor of the bank, and also from mortgage-backed securities, where the bondholder has a secured interest in the cover pool but has no claim on the issuing bank.

Due to their dual recourse security, covered bonds generally attract the highest possible AAA credit rating (which is higher than the bank issuer's own ratings) and are therefore a cheaper form of funding for banks than standard bank bonds.

The Reserve Bank of New Zealand (Covered Bonds) Amendment Bill, designed to help local banks secure stable long-term funding and to provide overseas investors with certainty, is currently before Parliament's Finance and Expenditure Select Committee.

'Covered bonds add incremental constraints'

Meanwhile, PwC says banks should be wary not to place too much reliance on covered bonds.

"The use of covered bonds adds incremental constraints that banks need to manage together with other existing constraints," says PwC. "Covered bonds help with the (bank's) liquidity ratios but do not reduce risk-weighted assets or the leverage ratios."

"With a growing proportion of the balance sheet encumbered, at some point, what may be a solution for liquidity, can become a problem with leverage and/or capital. The potential benefits for covered bond programmes needs to be carefully evaluated, in context of the respective regulatory framework governing the programme, and the subordination of non-secured bondholders in the event of insolvency of the issuer."

Although covered bonds have been issued in Europe for more than 200 years, they're a recent development in other parts of the world including New Zealand, where legislation either has recently been introduced, or is being introduced. Like the Reserve Bank of New Zealand, regulators elsewhere have defined and set thresholds to limit covered bond issuance, with New Zealand's 10% of the issuer's assets at the high end of what's allowed.

Australian law sets an 8% limit of the issuer’s domestic assets. In North America Canada has set a limit of 4% of total assets and the United States is eyeing a limit of 4% of liabilities. Singapore has a proposed limit of 2% of the issuer’s assets.

Across the European Union there's no single, harmonised framework for covered bonds. In Italy PwC says depending on the capital ratio of the bank, there are limits on the amount of assets that can be transferred to a covered bond special purpose vehicle versus the total volume of assets eligible as collateral on the balance sheet of the bank. Restrictions are lower for banks with higher capital ratios.

In Spain the issuance of mortgage covered bonds is limited to 80% of eligible mortgages and public sector covered bonds are limited to 70% of eligible public loans. In the Netherlands the regulator sets a nominal limit of covered bonds outstanding versus the total assets of the issuer bank on a case-by-case basis and so that the ratio remains at a "healthy" level.

In Britain when the bond issuance reaches 4% of total assets, the Financial Services Authority expects the issuer to discuss possible implications of the issuance and mitigating actions. However, an upper "soft limit" is 20% of total assets, though actual limits vary on a case-by-case basis, PwC says.

See all interest.co.nz's stories on covered bonds here.

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