Banks prepare to issue billions of dollars worth of covered bonds (update 1)

New Zealand’s major banks have been given the green light to start issuing up to NZ$16 billion NZ$19 billion worth of covered bonds, or debt securities backed by the cashflows of mortgages written by the banks, as a new form of fund raising to help bolster their balance sheets.

(Update corrects after the Reserve Bank corrected its earlier guidance).

A Reserve Bank spokesperson told interest.co.nz there were no legal impediments preventing banks from issuing covered bonds and the central bank was comfortable with them doing so. The comments follow the Reserve Bank’s revelation in last week’s six monthly stability report that it was working on the development of a specific policy for covered bonds.

A covered bond is a senior debt instrument secured by an actively managed pool of assets. The assets used to secure such bonds overseas include mortgages, public sector loans and even ship loans. The Reserve Bank says it is likely New Zealand covered bonds would be secured over mortgage loans. Covered bonds are popular in Europe, where €4 billion to €5 billion worth have been issued weekly in recent months.

BNZ’s director of capital markets, Mike Faville, says issuing covered bonds is something the BNZ is looking at closely.

“We understand that we’re not alone, other banks are also looking at the prospect closely,” Faville added.

Spokeswoman Astrid Smeele said ANZ New Zealand welcomed discussions with the Reserve Bank on covered bonds and would be assessing the merits of them as a product.

The central bank has told the banks covered bond issuance equivalent to less than 5% of their total funding assets would “not be cause” for concern. As of March, total bank funding assets stood at NZ$323.7 billion NZ$375.2 billion at the end of April according to Reserve Bank figures. Based on that figure, up to NZ$16 billion NZ$19 billion worth of covered bonds could ultimately be issued.

An important factor of covered bonds is that investors have a priority claim on the mortgages that the bonds are secured by, effectively ring fencing security on the bank's balance sheet. So in the event of a default by the bank issuer, depositors’ claims are diluted. For this reason Australia’s Banking Act currently bans covered bonds.

But, as one industry source puts it, there is a flip side to this for depositors. If banks are able to achieve longer term funding because they can offer covered bonds, if they can access new markets through covered bonds and a wider pool of investors, then they are less likely to default.

“The risk [to depositors] that might eventually happen after default, is made more remote,” the source said.

The covered bond market is predominantly a European investor and issuer one with more than 25 active market jurisdictions and issuance dating back more than 200 years. Major investors include credit institutions, investment funds, pension funds, insurance companies and central banks. But although the biggest target market for New Zealand banks issuing covered bonds would be European investors, local institutional investors are also interested, according to Tyndall Investment Management head of bonds and currency, Fergus McDonald.

“We’d have a look and like always it comes down to the pricing, whether it looks appropriate risk-return for us,” McDonald said. “It is something that increases the flexibility for fund raising for the banks as well.”

The major banks are looking for new sources of funding to help meet the Reserve Bank’s core funding ratio (CFR) which was introduced last month. The CFR requires banks to fund 65% of their loans from either retail deposits or long-term wholesale funding with maturities of more than one year. Covered bonds are generally issued for between five and 10 years.

Last November the central bank estimated the main banks all had a CFR above 65%, but only just in many cases. It plans to increase the CFR to 70 and ultimately 75% by mid-2012. This comes in the wake of the global financial crisis, amid Reserve Bank concerns the banks are vulnerable if ‘hot’ international wholesale money markets freeze, as they did when Lehman Brothers collapsed. It’s also against a backdrop of fierce competition for retail deposits, with banks paying interest on deposits close to the cost of their wholesale funding.

Covered bonds generally attract AAA credit ratings, which would given them a higher credit rating than any of the AA rated ANZ, ASB, BNZ or National Bank and AA- rated Westpac. This means the banks can issue the bonds at a lower margin achieving cheaper funding and, in theory at least, this could feed through to the interest rates charged to customers’.

Covered bonds are generally issued at 50-60% of whatever the standard senior bond spread is. For example, if HSBC issues five-year senior AA rated bonds at 100 basis points over the swap rate, it should be able to issue AAA covered bonds at 50-60 basis points over that swap rate.

The Reserve Bank spokesperson said the central bank had recently been looking at providing a formal position on covered bonds. Research for this included discussions with overseas investment banks, regulators and ratings agencies. It has also reviewed the situation in other countries. It hasn’t made a decision on whether or not to seek a legislative framework covered bonds. A consultation process will kick-off in the second half of the year.

“However, there are no legal impediments in New Zealand that prevent banks from issuing covered bonds and the Reserve Bank is comfortable with banks issuing them if they find that an efficient funding channel,” the spokesperson said.

This article was first published yesterday in our paid subscriber email for bank executives, regulators and other industry experts. Subscribe here or email bernard.hickey@interest.co.nz