It’s the 18th Century in Canada Again as Covered Bond Sales Soar

Frederick the Great
Banks Issuing Covered Bonds To Reduce Their Funding Costs In Volatile Markets.

Source: Bloomberg

Canadian banks are issuing record levels of covered bonds, mortgage-backed debt pioneered in Prussia, helping them to lower funding costs in volatile markets.

The country’s lenders have sold 5.75 billion euros ($6.5 billion) of covered bonds this year, up about 50 percent from the same period last year and the highest in Bloomberg records dating to 2008. Two developments have driven the surge: investors are demanding higher yields to hold bonds over safer government debt, and new rules require Canada’s six-biggest banks to issue costlier bail-in debt, which converts to equity in a bank failure.

Some banks have saved more than 40 basis points selling covered bonds instead of unsecured debt.

“It’s just kind of a perfect storm in the context of covered bonds,” said Marty Halpin, head of balance-sheet management at HSBC Bank Canada, which sold the securities late last year. “Covered bonds are a very attractive funding source compared to say six months ago.”

Covered bonds were pioneered in 18th-century Prussia, when Frederick The Great let aristocrats, churches and monasteries raise money by pledging their estates as collateral. They’ve typically had higher credit ratings than the banks’ unsecured debt because they have a senior guarantee from the issuer and first call over specific pools of assets.

European Tradition

The debt, which is held on bank balance sheets, is popular in Europe but eschewed in the U.S. in favor of asset-backed securities, which are sold off the balance sheet. Canada is the largest non-European issuer of the bonds with about C$160 billion ($120 billion) outstanding, according to the Canada Mortgage and Housing Corp., the federal agency that registers the issues and makes sure banks comply with rules governing disclosure and collateral.

On Tuesday, Royal Bank of Canada priced 1.75 billion euros of five-year covered bonds to yield 0.354 percent, equivalent to about 77 basis points over Canadian government debt if the proceeds were swapped into loonies, according to Bloomberg calculations. That compared with a spread of about 118 basis points for its 2 billion euros of senior unsecured bail-in bonds due Sept. 2023, according to bid prices collected by Bloomberg.

All five deals priced by Canadian banks this year mature in 2024. In addition to the RBC deal, Desjardins Group sold 750 million euros of the debt, Bank of Montreal tapped the market for 1.25 billion euros, Bank of Nova Scotia raised 1.25 billion euros and National Bank of Canada 750 million euros. A total of 25.9 billion euros of covered bonds were sold last year.

Yields Climb

Spreads between corporate bonds and benchmark government debt have widened as global markets convulsed over trade tensions, concerns about growth and U.S. politics. Yields on unsecured bank debt were trading at about about 116 basis points over federal Canadian debt on Thursday, up from about 94 basis points six months ago and 73 basis points a year ago, according to Bloomberg Barclays Canada Aggregate Corporate index.

Relative funding costs may rise further, especially for the six largest banks, which are expected to issue about C$153 billion of senior bail-in debt over the next three years, according to Bloomberg Intelligence estimates.

“We look at covered bonds favorably compared to the unsecured because they are less confidence sensitive,” said David Beattie, who covers bank ratings at Moody’s Investors Service in Toronto. “Investors are less likely to flee an institution that’s having problems if they have over-collateralization available to them with very solid assets.”

Smaller Banks

The Office of the Superintendent of Financial Institutions of Canada, the country’s bank regulator, is reviewing whether to boost the cap on covered bond issuance, which stands at 4 percent of risk-weighted assets, among the lowest in the world. That would be welcome by issuers.

“We continue to view such an increase as favorable,” Jean-Francois Cadieux, a spokesman for Montreal-based National Bank of Canada, said in an email. “Covered Bonds provide a valuable source of stable, longer-term, efficient and diversified funding to our organization.”

It can be a costly endeavor for smaller issuers to set up a program, Les Badzioch, head of securitization for CMHC said in an interview. Banks have to keep track of the collateral and pay other fees. The agency cut the cost for initial issuers by almost 60 percent earlier this year, he said.