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Always waiting

14 May 2019
Richard Kemmish

Optimists have been predicting growth in the dollar covered bond market for years. Why have they been so consistently wrong? And what will make them right?

I confess. I’m one of them. Before the financial crisis I was trying to persuade sceptical American investors that covered bonds are a great asset class and that they were going to take off in dollars real soon. At least one of those was correct.

Of course, there are covered bond denominated in US dollars, but none of them exist for the reasons that we said would drive the expansion of the market. They are all a bit niche.

Firstly, there are the dollar Pfandbrief. Although euro denominated deals will always be cheaper for German issuers, the cost and sheer hassle of swapping their dollar denominated assets into euros is often greater than the difference in funding costs – the risk capital for the FX swap, for example, can be very expensive.

There aren’t that many dollar denominated assets in cover pools, just enough to keep the larger issuers interested. The paucity of supply, the hassle of regulation AB and the – let’s face it – lower disclosure standards for European banks – means that these bonds are rarely going to be 144a registered. And if they are targeted at off-shore dollar investors, more often than not they are the same investors that buy that issuer’s euro deals (thanks for the extra 20 basis points!).

One of the quirks of the dollar Pfandbrief market is that they are the only covered bonds that are accepted as repo collateral by the Fed. No-one would pass such a rule nowadays but, as someone at the Fed once told me, expanding the eligibility to other covered bonds makes perfect sense but it isn’t exactly top of the ‘to do’ list.

Apart from the Germans, a lot of dollar issuance has been from countries such as Australia, Canada and the UK. Other than speaking English and having good name recognition in America what these issuers usually have in common is a big wholesale funding need and active securitisation programmes. So they tend to be comfortable with 144a disclosure and have lines in place with even the medium sized US investors.

These are the issuers who have been largely to blame for disappointing $ covered bond issuance in recent years. British issuers in particular have been missing. The reasons are obvious – the non-dollar alternatives have just been too good for the modest total funding needs: euro market spreads have been squeezed by central bank purchases, those same central banks have been offering very cheap term repo facilities.

It isn’t just the dollar market that has suffered, the overall covered bond market is now smaller than it was in 2010, despite all of the new countries coming online. The dollar market, as the marginal source of funding, will always have a highly leveraged exposure to the total market size.  

Which – at the risk of being a Pollyanna - leads me to the first reason to be an optimist. Just as that marginal market status has hurt dollar issuance so bad as the market contracts, it will benefit issuance as Europe’s banks learn to live without central bank support. Many investors have pulled out of covered bonds in Europe as a result of low absolute yields (and the relative appeal of senior preferred bank debt), the euro market’s capacity to absorb a significant uptick in issuance is questionable. 

Another reason to be optimistic is Basle. There is a big difference between a suggestion from Basle and a regulation for US banks, but the proposal that all countries globally should grant a lower risk weight for covered bonds at least shows the direction of travel – the European Union’s covered bond directive, in particular it’s ‘equal treatment’ clause is a further sign.

The elephant in the room though is the possibility of US domestic issuance. US readers will have their own (I’m guessing mainly sceptical) views on that. I’m looking forward to hearing more about that at The Euromoney North America Covered Bond Forum in Toronto next month.

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