Room to grow for covered bonds, 2017 well under $200B limit : DBRS report

At the end of October, the six banks plus the Fédération des caisses Desjardins du Québec have more than $140 billion of covered bonds outstanding

Source: Financial Post

Covered bonds, which have been part the financial landscape in Europe for about 250 years, continue to be an attractive source of funding for a group of Canadian financial institutions, specifically the chartered banks and large regionally based credit unions.

In fact, according to a recent report by Dominion Bond Rating Service for the first 10 months of 2017, issuance of the AAA-rated security that is based on an underlying pool of residential mortgages and the credit rating of the banks, was the second-highest for any similar period. For the period January to October, the entities rated by DBRS has issued $17.5 billion of covered bonds, a level of issuance that is only second to the $40.8 billion issued in 2016.

So while issuance is slower than it was in 2016, the financial institutions are interested in issuing covered bonds for a good reason: They are able to borrow at very low interest rates for short to medium terms and in a variety of currencies ranging from euros, to British pounds, to US$ to A$.

In January, Scotiabank raised 1.25 billion euros at 0.125 per cent for five years. A few months later TD also scooped up 1.25 billion euros but was required to pay 0.50 per cent for seven-year money, while last month BMO garnered 1.5 billion euros at 0.20 per cent for a five and one-quarter year term. In other currencies, CIBC raised 525 million pounds at 1.125 per cent for five years and US$1.75 billion for five years at 2.35 per cent.

There are at least three main differences between the two years. In 2017 borrowings in euros ($5.76 billion) are about one-third the levels reached in 2016 ($19.05 billion); issuance in US$ is about half the level in 2017; and there has been no domestic issuance compared with $4.5 billion in 2017.

At the end of October – and following issuance by National Bank and Bank of Montreal in that month – the six banks plus the Fédération des caisses Desjardins du Québec have more than $140 billion of covered bonds outstanding.

Covered bonds have travelled on a path largely determined by the regulators in the 10 years that they have been around. In 2007, the Office of the Superintendent of Financial Institutions (OSFI) gave the green light provided that issuance was no more than four per cent of the institution’s assets.

Following the global financial crisis, the rules were changed, all part of the plan to ensure that the banks were well capitalized. Legislation was introduced in 2012 became effective in early 2013 following he release of the Canadian Registered Covered Bond Programs Guide. That guide was released by Canada Mortgage and Housing Corporation.

One of the major changes in the new guide was that residential mortgages insured by CMHC could not be included in the underlying pool on which the covered bonds were issued. At the time the feeling was the CMHC timely payment guarantee acted as a subsidy to the issuers. Remove that subsidy, ran the argument, and the issuers would be required to pay the market return while investors would also receive a market return.

In late 2014, there was another regulatory change when a new definition of total assets was developed.

Using aggregate data, it seems that there is room for considerably more issuance. In its report DBRS said the amount of covered bonds outstanding is still a long way from the maximum (almost $200 billion) that can be issued. In reality, though, each bank faces its own limit. Its understood that CIBC is closer to the limit than the others.