Tyndall: Are domestic Covered Bonds the solution for banks and investors?

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While Covered Bonds may offer an appealing funding option for banks and give investors alternatives, there are risks entailed, according to Tyndall’s latest research White Paper, “Are Covered Bonds the solution?”

While Covered Bonds may offer an appealing funding option for banks and give investors alternatives, there are risks entailed, according to Tyndall’s latest research White Paper, “Are Covered Bonds the solution?”

The suggestion to introduce domestic Covered Bonds was contained in the Federal Government’s proposals for a “Competitive and Sustainable Banking System”.

The Federal Government then released an Exposure Draft on Covered Bonds legislation in March 2011. Comments on the draft are due by 22 April 2011 before the Bill in its final form is tabled in Parliament.

Introducing Covered Bonds form part of a strategy to: create an additional AAA-rated funding source; lower bank funding costs; create competition in the bank lending market; and address the issue of the liquid assets requirement in Basel III.

A Covered Bond is a security issued by a bank with assets (usually mortgages, but sometimes other loans) assigned to provide security for the debt. Typically the size of the asset pool (or ‘cover pool’) is larger than the bond issue.

As the Tyndall paper, co-authored by John Sorrell, head of credit at Tyndall Investments, and senior credit analyst Ileria Chan, explains, unlike a residential mortgage-backed security (RMBS), Covered Bond cashflows are funded by the financial institution and not by the cashflows of the pool of assets.

Thus a Covered Bond has regular payments and no prepayment, so that it resembles a traditional bond issue.

Dr Sorrell says that it is possible we could see domestic Covered Bonds traded before the end of 2011.

“They offer investors further high-quality credit investments but investors must remember that they are still bank debt and not a direct substitute for government-guaranteed bank debt.

“Indeed, despite the government’s intention, while the introduction of Covered Bonds in Australia is a strong positive for the major banks, they may weaken, rather than enhance, competition in the banking sector and could further widen the funding access gap between the major and the second tier banks.

“Covered Bonds may also cause consequences for senior debt holders and bank depositors leading to potential conflicts and regulatory risk,” he said.

The Tyndall paper notes that the size of the Australian Covered Bond market will be constrained by investors’ existing senior debt exposures, so for most Australian portfolios, offshore issues of Covered Bonds available domestically will probably still be of more interest.

Nevertheless, Dr Sorrell said that the Tyndall fixed interest team will itself consider Covered Bonds as a potential sector for investment, depending upon pricing and liquidity, and adding Covered Bonds to the total fund exposure to each issuer.

The Tyndall White Paper points out that Australia is one of the last developed countries to introduce Covered Bonds, and considers why they are now being introduced, who will buy them, and what the risks are.

Co-author Ileria Chan says that unless controlled, Covered Bonds could lead to conflict and regulatory risk for senior debt and depositors.

“They do have some attractive risk features – perhaps the most important for investors is the dual recourse to the bank and to the collateral, while senior bank investors can only claim on the bank and RMBS investors can only claim on the collateral. This is an important risk enhancement but comes at a price in yield to investors.

“Also, as the assets used to provide the cover must be assigned unambiguously to the Covered Bond issue it does result in a reduction to the amount of assets available to other unsecured lenders, including depositors.

“In addition, risks are not completely removed since the assets are correlated with the issuer and are long-dated illiquid assets,” Ms Chan said.

Dr Sorrell added that being able to issue Covered Bonds does provide an attractive alternative funding option in a bank’s funding mix – but perhaps not as attractive as might at first appear and they may impact on lower-rated entities’ ability to compete.

“In Europe Covered Bonds form a deep and mature market. The European experience showed that they were one of the first asset classes to recover and provide liquidity during the credit crisis.

“Canadian investors have preferred senior debt to Covered Bonds for their banks and Canadian banks have issued their Covered Bonds outside their borders.

“Australian banks may, likewise, find more acceptance for their Covered Bond issues offshore than they will domestically, as they could cannibalise their Australian dollar senior debt programs,” he says.

Ms Chan believes that overall they have a place for investors, but the risks need to be understood and priced appropriately.

“Covered Bonds are well suited to the needs of investors who can only invest in AAA-rated securities (i.e. sovereign funds) or have a minimum allocation to AAA-rated assets. They potentially also offer an alternative to supras or government guaranteed debt.

“For investors who are able to invest in senior bank paper and have comfort with the issuer’s name, Covered Bonds may be less appealing since they can use up limits on exposures to these names with lower yielding investments,” she said.

Tyndall Investments Australia offers Australian equities and Australian and global fixed interest funds to retail and institutional investors in Australia. It has over A$22 billion in funds under management (as at 31 March 2011).

Tyndall Investments is a wholly owned subsidiary of Nikko Asset Management Co., Ltd., one of the largest asset management companies in Japan with approximately A$175 billion in funds under management (as at 31 March 2011).

Are Covered Bonds the solution?” is available from www.tyndall.com.au


For more information please contact:
John Sorrell – 02 8275 6650
Ileria Chan – 02 8275 3563

19 April 2011