On a recent visit to a prominent London fund manager, Euromoney watched one portfolio manager pound his fist on the table, incredulous that regulators were proposing to turn senior debt instruments into something that begins to resemble equity. Anathema is a word that springs to mind.
As a recent survey of investors conducted by JPMorgan shows, many investors see senior bank debt as less investable if bail-ins are imposed. That’s a worrying prospect for global banks seeking $3 trillion of funding by the end of next year. It raises the question of what will remain an investable asset within the bank debt universe?
The answer could be covered bonds. In theory, covered bonds can’t be haircut – that is, unless you radically change the law. The law as it stands stipulates that covered bonds must be overcollateralized, so that there is an excess of income to meet every interest and principal repayment. In the event of insolvency, the cover pool of the assets behind the bonds gets segregated and separated, and then managed by another party. For example, in Ireland those assets would be managed by the National Treasury Management Authority.
Covered bonds are going mainstream. As one debt capital market practitioner tells Euromoney, an unnamed European central bank, which constructs its own fixed-income investment index, has increased its covered bond constituency to 26.2%, up from 10% a year ago. After a quiet beginning to the year, business in European covered bond issuance has been brisk, with €347 billion issued year-to-date, just shy of the peak of €351 billion in 2006.
Practitioners say the beauty of the covered bond market lies in its simple business model, dating back to 1852: banks lend to their clients, and then go to their investor base based on their lending decisions. The model is grounded in old-fashioned trust which, because of its secured nature and overcollateralization, means it creates a dynamic where borrowers and lenders are working with each other for mutual benefit. This means that in many cases when borrowers get into difficulty the various stakeholders sit down and sort it out. This is not the case in securitization markets.
JPMorgan says that given the higher expected risk premiums for senior unsecured debt, issuers are likely to resort more and more to secured borrowing, such as covered bonds, because the loss given distress would likely be limited given the priority pledge on the collateral pool, with losses only accruing in the event that there is a shortfall in the value of the collateral assets. Furthermore, the collateral would also have a pledge on the remaining assets of the issuer and be pari-passu with senior unsecured bondholders for any shortfall in the value of the cover pool.
However, the increased issuance of covered bonds could very well undermine the effectiveness of bail-ins themselves, because a larger proportion of senior unsecured assets would be encumbered since they would be pledged to covered bond investors.
Another side-effect might be that it would act as an incentive for banks to develop business lines that could be funded by covered bonds, at the expense of other lending activities, which might already be facing higher funding costs. It could become a self-reinforcing loop. In the meantime banks are likely to take a look at the size of their mortgage books, and attempt to increase their allocation of funding from covered bonds as senior markets remain challenged.
It might not solve the problem, but every little helps.
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