In September, Royal Bank of Canada made history when it issued the first ever SEC-registered covered bond. The Canadian bank launched a $2.5 billion five-year deal at mid-swaps plus 35 basis points.
Foreign banks have long been issuers of unregistered covered bonds in the US but the deals are sold as private placements. David Power in RBC’s corporate treasury explains that this structure has drawbacks for investors. "Unregistered, there is a lack of eligibility for key bond indices and to Trace – the price transparency system in the US that allows investors to know where bonds are trading rather than relying on the dealer," he says. Private placements are also tailored to large institutional investors, such as insurance companies and pension funds. Power says the registered format therefore appeals to a broader range of investors and should ensure greater liquidity in the bonds.
|Ben Colice, head of covered bond origination at RBC Capital Markets|
In a research note, George Lazarevski, analyst at BMO Capital Markets, said: "We do not expect other Canadian banks to quickly follow suit given that they still need to develop new covered bond programmes backed by uninsured mortgages, the lack of clarity on the new legislative requirements, and the burdensome regulatory requirements to issue a SEC-registered deal." RBC reportedly worked for two years on the structure.
However, RBC’s deal lays a foundation that should save other banks time in establishing their programmes.
"Registration is a longer-term commitment, but other issuers may be able to leverage the work we have done. Certainly the advantages of a broader investor base make it worthwhile," says Colice. Potential issuers, for example, can use the no-action letter with which the SEC responded to RBC’s application, saying it would not penalize the bank for selling the bonds as registered.
Colice adds that demand from investors looking for dollar-denominated deals might encourage other foreign banks to issue. Foreign issuers have printed more than $23 billion in private-placement US dollar-denominated bonds already this year in response to investor demand for bank debt.
Lazarevski points out that the economics of issuing a US dollar-denominated bond instead of issuing domestically are certainly attractive for Canadian banks.
"We could see less domestic deposit note issuance given the attractive economics of this deal [being] 20 basis points tighter than domestic deposit notes on a swapped equivalent basis," he says. "[Furthermore] despite the collateral pool being uninsured mortgages, investor demand was very strong, as exhibited by the large order book, and the incremental spread to issue an SEC-registered covered bond relative to covered bonds backed by CMHC-insured mortgages was attractive, at less than 15bp."
Power explains that for RBC the registration process made sense as part of its global financing strategy: "Generally for transactions of this size around the world our practice is to use a registered format in every market, so it was natural to take this step in the US." He says the banks worked with the capital markets team and counsel to reach out to the SEC to understand how best to approach establishing a $12 billion shelf for registered bonds.
US banks lag behind
US banks, however, are still several years away from issuing domestic covered bonds despite long-running discussion with legislators. For more than five years, lawmakers have debated changes to covered bond legislation. Discussion revolves around clarity on how covered bonds would be treated in insolvency. The sticking point lies with the Federal Deposit Insurance Corporation, which takes over failed institutions’ assets in the US and must sell them off in a way that yields the best outcome for the US taxpayer. Should covered bonds be ringfenced, so that if an institution fails the covered bond investor has protection, leaving the FDIC and the taxpayer in second place?
Until the credit crisis there seemed little need for covered bonds on the part of US banks from a capital perspective. Banks could simply securitize pools of loans or mortgages and get them off the balance sheet, and investors in return enjoyed a higher yield than would have been the case with a covered (and therefore safer) bond. Now that regulatory changes are requiring financial institutions to hold more of their assets on the balance sheet, covered bonds look like a good alternative to securitizing assets.
So far only Bank of America and Washington Mutual have issued covered bonds, and proponents of them point to the fact that WaMu’s bonds were taken over by JPMorgan which should alleviate fears about insolvency.