Although covered bond issuance is booming in the UK, legislation to bring the country in line with the EU is in the pipeline. Michael Marray reports on the advantages this will bring for the market.
The UK has had the fastest growing covered bond market in recent years, with issuers taking the structured route in the absence of any UK covered bond law. And 2007 is expected to be another record year for new issuance.
In spite of the rapid development of the market, though, the UK government is nonetheless moving forward with legislation, mainly driven by a desire to make UK covered bond products compliant with EU Undertakings for Collective Investment in Transferable Securities (UCITS) legislation, which assigns a 10% risk weighting to eligible covered bonds.
Industry players are expecting to see the draft of the UK’s planned legislation from HM Treasury during the first half of this year. The law is due to be passed this year, although some sceptics note that a previous target to have a law in place at the beginning of the year was not met.
It is a significant event for the UK banks and building societies that are increasingly turning to covered bonds as a cheap and reliable funding source, but which currently pay a couple of basis points extra to investors. This is probably more because of the risk weightings than any investor bias against structured covered bonds, which have rapidly built up a strong following among global investors.
“Though there is an argument that there is a qualitative difference if you base your covered bonds on statutory law or on private contracts, I do not think that the market fully recognises this difference,” says Florian Hillenbrand, credit analyst at HVB in Munich.
“Apart from different degrees of liquidity, the price difference is more due to the differences in risk weightings and ECB [European Central Bank] repo eligibility,” Mr Hillenbrand says. “In the absence of legislation, UK covered bonds have a higher risk weighting than covered bonds from most other jurisdictions, and they are less liquid in terms of ECB repo. This needs to be reflected in the pricing.”
Karen Naylor, head of the European covered bond team at Standard & Poor’s in London, says: “We understand that the decision to pass a covered bond law in the UK has been taken not because HM Treasury sees defects in the current structures being used by issuers, but because it wants UK covered bonds to have UCITS status, which will mean a lower risk weighting.
“We expect that the planned law will provide an umbrella under which UK issuers will have considerable flexibility, rather than being overly prescriptive,” says Ms Naylor.
UK market flourishes
UK issuance continues to boom as individual issuers make a global marketing effort to broaden the investor base for their bonds. In February, HBOS was in the market with the 21st offering out of its €40bn covered bond programme established by HBOS Treasury Services, this time with a $3bn offering. And HSBC is a heavy issuer out of its combined residential mortgage-backed securities (RMBS)/covered bond programme.
In addition to big banks such as HSBC and HBOS, building societies such as Bradford & Bingley, Yorkshire Building Society and Nationwide have been issuing in size. In March, Northern Rock was planning another deal, denominated in euros.
Structural innovations continue, too. Last October, HSBC announced the creation of a €15bn covered bond issuance programme, under which both covered bonds and RMBS can be issued backed by the same pool of assets, which will be ring-fenced in a UK limited liability partnership.
Other very large issuers of both RMBS and covered bonds are expected to emulate the HSBC programme, which not only cuts down administration costs, but also allows HSBC to do offerings speedily.
“The HSBC funding platform illustrates what many market players have been saying for some time, which is that covered bonds and RMBS can co-exist, due to the fact that they have different investor bases and different drivers,” says Massimo Catizone, assistant vice-president, structured finance, at Moody’s Investors Service in London.
“Covered bond issuance is driven by the need to have a cheap source of funding, with the assets remaining on the balance sheet of the originator, whereas in RMBS the portfolio is transferred from an originator to an SPV [special purpose vehicle], which makes securitisation an interesting tool for balance sheet management purposes,” he says.
“I think that banks want the possibility to issue both covered bonds and RMBS on an ongoing basis, and once the basic set-up is in place, it is easy to issue on an opportunistic basis depending on market conditions,” he adds. “We may see other banks use the same type of programme, although you have to be a relatively large mortgage originator to make such a structure worthwhile.”
Currency variety grows
Issuance in a variety of currencies is also a growing trend among large UK issuers. “There is huge potential for covered bond issuance in currencies other than the euro and US dollar,” says Richard Kemmish, head of covered bonds at Credit Suisse in London. He points to a recent SFr300m ($246.5m) 10-year offering from HSBC, lead managed by Credit Suisse and ABN AMRO, as an example of this trend.
“UK issuers have been mainly focused on jumbo offerings but we will see a growing number of smaller deals, like those traditionally done by German banks, to tap into pockets of demand,” says Mr Kemmish.
He also expects to see more European covered bond issuers tap into the vast US investor base with US dollar offerings. “In the past, US dollar-denominated issues from European borrowers have been sold mainly to non-US investors, for example Asian central banks,” he says. “But the HBOS deal last November was aimed mainly at domestic US investors, with 76% of the bonds distributed in the US, and we are going to see more deals targeted at the growing domestic US investor base for covered bonds.”
After sounding out and educating US investors in mid-October, HBOS announced the $2bn transaction on November 8, and the books opened early on November 9. As a result of overwhelming investor demand, with interest in excess of $4bn, the books closed and the deal priced on November 10. The transaction, rated AAA, had a five-year bullet maturity and priced at mid-swaps flat. It was lead managed by Citigroup and Deutsche Bank.
Nonetheless, it is the euro that dominates covered bond issuance because most of the long-established covered bond buyers are in Europe. In addition, central banks such as those in Asia have been investing a higher proportion of their funds in euro-denominated assets.
The global strength of demand was illustrated in February, when Nationwide Building Society went to the market with a €4bn dual-tranche deal, lead managed by UBS, ABN AMRO and Deutsche Bank. The five-year tranche paid 4.125% fixed, and the 15-year tranche paid 4.375% fixed – 7 basis points (bp) over mid-swaps. Bankers say that there were more than €11bn worth of orders placed for the €4bn worth of bonds.
With that kind of appetite and such fine pricing, it is not surprising that covered bonds are becoming an increasingly important element of treasury managers’ funding strategies.
Fast evolution
It is only four years since the first ever UK covered bond was issued from HBOS, in summer 2003, but they have already evolved into a well-established asset class with a global investor base. Jumbo covered bonds still offer investors a significant yield pick-up versus AAA rated eurozone government bonds. For example, on a sample of 380 jumbos taken in January, the average spread over bunds was 17bp.
The signs are that spreads may tighten in coming years, particularly as more central banks either start buying mortgage-covered bonds or increase their portfolio allocations in both dollars and euros, as well as smaller currencies.
The big UK issuers, which can issue in size and some of which already have excellent international name recognition, are well positioned to benefit from the broadening and deepening of the global covered bond investor base.
