Sea change looming for Canadian covered bonds

Tue May 1, 2012 12:12pm EDT

LONDON, May 1 (IFR) - New collateral requirements will open Canada's bank-issued covered bonds to international investors, who have steered clear of the country's bank debt up until now.

Without a legal framework in place, many international investors have been effectively blocked from participating in covered bond programmes, which began in Canada in 2007.

But the new legislation should open the doors to outside investment, even though it bans banks from using government-guaranteed mortgages as collateral for covered bonds.

"The new legislation will add an extra layer of protection and comfort for conservative investors that have been unable to buy into Canadian covered bonds up until now," said Ted Lord, managing director and head of European covered bonds at Barclays.

The changes to the National Housing Act will require 10% overcollateralisation for covered bonds, which in Canada can only be issued by banks and the Canada Housing Trust.

The legislation comes as the Canadian government tries to get to grips with a sky-rocketing property market that has seen prices triple in some parts of the country.

"The proposed changes should increase housing finance costs and decrease housing credit availability," said analysts at RBS.

"The change should increase residential mortgage funding costs. Canadian banks will likely have to pay more to investors to accept an uninsured collateral pool, and could have to provide more assets to the collateral to achieve the desired credit rating."

The legislation, introduced last week, will also see the Canada Mortgage and Housing Corporation (CMHC) take responsibility for administering the new framework.

FUNDING IMPACT

A wide range of investors have shown interest in the country's covered bonds, due to their Triple A rating and the underlying guaranteed mortgages, which make the bonds seem more like sovereign debt than bank debt.

But Canadian banks have had limited scope on such funding, as a number of institutional investor accounts require their bond investments to be under some kind of legal legislative framework.

In the past, Canadian banks issued covered bonds under a contractual framework that involved a bank establishing a covered bond programme, creating a cover pool and selling assets into that pool.

The cover assets were then sold to a bankruptcy remote entity - a special purpose vehicle which investors have priority claim over.

While the new legislation is ultimately expected to make the covered bond market more solid, the removal of CMHC mortgages as possible collateral marks a sea change for the sector.

The majority of Canadian covered bond issuance over the past two years has had collateral pools backed by those mortgages.

Along with the requirement for the country's banks to stump up the overcollateral, the changes are expected to drive up the banks' cost of funding by around 10bp.

Analysts at Fitch said the exclusion of insured mortgages is likely to increase the cost of future issuance via higher credit enhancement levels.

"This measure may also cause a contraction in credit availability, which has the potential to negatively affect home prices," they said.

With most of Canada's banks currently in a pre-earnings funding blackout period in May, it will be some weeks before we know if the changes ultimately shrink or grow the covered bond market.

Covered bonds currently represent only a small portion of funding for Canadian banks, as they are limited to 4% of total assets, and some institutions are already near the cap.

Canadian banks ramped up issuance earlier in the year when reports of the new legislation first emerged, and covered bond issuance is already at CAD12.4bn year-to-date, compared with CAD22bn for all of 2011.

But one thing seems clear: investors are likely to be more discerning now that the guaranteed collateral has been removed, meaning it may be more difficult for riskier issuers to get the funding.

"For those issuers that have demonstrated a strong business performance throughout the financial crisis, there should be little change in funding costs. For those that have a more volatile earnings stream, there could be a slight change, although Canadian banks are generally favoured by investors globally," said Lord.