By Gareth Vaughan
Institutional investors buying bank covered bonds ought to be wary that, although in theory they're ahead of retail depositors in the pecking order if a bank issuer goes bust, governments tend to come to the assistance of retail depositors who are also voters, Tyndall Investment Management says.
In a research report on covered bonds, Tyndall's Sydney-based head of credit John Sorrell notes that the concept and legal framework of covered bonds has never been tested as there hasn't been a case involving a default of a covered bond in the past 100 years.
"There have been cases where banks have failed but covered bonds are repaid - for example, Northern Rock in the UK - but these cases have been resolved without challenging the legal strength of the claims of covered bonds," says Sorrell. "If the conflict is, however, with retail depositors, legal challenges are more likely."
So far the BNZ is the only New Zealand bank to have issued covered bonds. Since its first issue last June, BNZ has issued NZ$2.57 billion worth of covered bonds with issues both to European and local institutional investors. However, Westpac delayed a 1 billion euros (NZ$1.81 billion) issue in February and other banks including ANZ, ASB, Kiwibank and TSB Bank have expressed interest in at least considering issuing covered bonds.
Covered bonds are senior debt instruments backed by a dedicated group of home loans assigned to provide security for the debt known as a “cover pool”, and are usually issued for five to 10 year terms. The way they're structured means if the issuing bank defaults, the assets in the cover pool are carved off - or ring fenced - from the bank issuer’s other assets solely for the benefit of the covered bondholders.
This ring fencing of a chunk of a bank’s balance sheet is why covered bonds have been banned by the Australian Prudential Regulation Authority (APRA) as, in the event of a default by the bank issuer, depositors’ claims are diluted. However, the Australian government decided in December to change the law, and introduce legislation to allow banks to issue covered bonds.
Sorrell notes that unlike with residential mortgage backed securities (RMBS), covered bond cashflows are funded by the issuer and not by the cashflows of the mortgage pool. Covered bond investors have dual recourse to the bank and mortgage pool collateral while senior bank bond investors can only claim on the bank, and RMBS investors can only claim on the collateral.
There's no specific law preventing banks from issuing covered bonds in New Zealand. The Reserve Bank says it's comfortable with banks using up to 10% of their total assets as collateral for covered bonds. After industry consultation, the central bank says any required legislation for covered bonds is likely to be introduced to Parliament this year.
Sorrell says that what has been noticeable during the global financial crisis is government's around the world tending to protect the interests of retail depositors given there are millions of them and a much smaller number of often foreign covered bondholders.
"This is not surprising, given that alienating retail depositors creates considerable political risk. It is still a matter of conjecture on how a government might handle balancing the interest of retail depositors and of covered bond investors in an event of bank bankruptcy, but investors in covered bonds need to appreciate the political risk in such a circumstance."
Sorrell told interest.co.nz the prospect of being subordinated to retail depositors was probably not something most covered bondholders would be "overwhelmingly enthralled with." However, he said getting to a discussion about the ultimate rights of retail depositors and covered bondholders was "on the edge of likelihood."
"By the time we're coming to a discussion between retail depositors and covered bondholders we're really suggesting that whatever bank we're talking about is not only broken, it is absolutely crunched because we'll have already had to get rid of all senior bondholders and everything else," Sorrell said.
"So it's not a high probability issue."
Nonetheless he said he was closely watching what happens in Ireland, where the country's troubled banks issued billions of euros worth of covered bonds. (See a recent Standard & Poor's release on Bank of Ireland's UK covered bond programme here).
Covered bonds are expected to allow banks to achieve lower funding costs and longer-term financing. Due to their dual recourse they are considered a better credit risk compared to unsecured senior bank debt and typically receive the highest available AAA credit rating from the international credit rating agencies. They typically trade at tighter spreads than senior bank bonds. For example, the BNZ's 3.125% November 2017 covered bond was marked at a spread of 56 basis points over the swap rate and the same bank's 4% March 2017 senior bond was marked at a 125 basis point spread.
Aside from being a source of cheap funding, the banks say they want to issue covered bonds to help meet the Reserve Bank's core funding ratio (CFR). Introduced on April 1 last year, the CFR sets out that banks must secure 65% of their funding from retail deposits and wholesale sources with maturities of more than one year. The central bank plans to lift the CFR, designed to reduce New Zealand banks reliance on short-term offshore wholesale funding, to 70% this July and 75% in July 2012.
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