Trailblazer: Kookmin's covered bond earlier this year was the first ever issued out of Asia-Pacific

South Korea's Kookmin bank issued the first covered bond out of an emerging market earlier this year. It was lapped up by investors although its pricing has been questioned. But more importantly, is it the first of many other emerging market banks to look to covered bond investors for funding? Writer Joanne Hart

Covered bonds have long been used in Europe. They are backed by a pool of high-quality assets - frequently mortgages - and investors have recourse to the borrower and the assets in the event of default. This 'dual recourse' security blanket has given covered bonds a reputation as one of the safest and most robust asset classes in the financial markets.

 In the heady days before the global credit crunch and widespread recession, the safe aspect of covered bonds seemed less important. Issuers largely preferred securitisation, where they were disintermediated from the assets in any given transaction. Investors were happy to go with the flow.

 They were a lot less happy, however, once Lehman Brothers collapsed and the pitfalls of securitisation were laid bare with a vengeance. Investors fled the market and bank funding became virtually impossible without government guarantees. But the covered bond sector suffered less than almost any other and was among the first to recover, even in the darkest days of 2008.

Pioneering bond

 It is small wonder then, that when South Korea's largest bank, Kookmin, was keen to raise $1bn over a five-year term, it looked at covered bonds. Discussions began last winter but the deal was finally launched in early May, and it is the first covered bond ever issued in Asia-Pacific.

 "Asian banks, including those from Korea, had been talking about covered bonds for years but it never really happened," says Will Ross, head of HSBC's financing solutions group in Asia-Pacific. "Then issuers saw that the covered bond market remained open in Europe even last year and that started people thinking they could replicate the structure in other markets."

 The Kookmin deal was certainly popular. Launched at a spread of 500 basis points (bps) over mid-swaps, it attracted $6bn of orders from 250 investors in Asia, Europe and the US. By the end of the first day of trading, the spread had come in by 90bps, which prompted widespread criticism that the lead managers HSBC and Citi had overpriced the deal.

 "This was a brand new deal. Investors needed a new issue premium and a structural premium based on the market conditions at the time of issuance," says Paul Au, head of syndicate at Citi.


Paul Au, head of syndicate at Citi

Change in sentiment It is almost inevitable that rivals will highlight defects in other lead managers' deals, but the tightening of the spread on the Kookmin transaction clearly reflected the dramatic change in market sentiment - and market conditions - in the six to eight weeks leading up to the launch.

 "The success of the deal seems inevitable now but it was much more open to question earlier this year. If you had said to anyone in February, for example, that you were going to do a $1bn covered bond issue for a Korean bank, they would have thought it impossible. Even in March, there was a great deal of scepticism among traditional borrowers," says Mr Ross.

 Andrew Porter, HSBC's head of covered bonds, agrees that Kookmin's ability to issue the covered bond was certainly not a done deal. "Until May, investors were focused almost exclusively on the government guaranteed sector," he says. "Since then, there has been a collective extension of confidence. In fact, Kookmin was able to come with a $300m three-year senior unsecured deal a month later at 390bps over mid-swaps."

 For market watchers in Europe, Asia and the Americas, the key question now is this: will other emerging market banks follow Kookmin's lead and tap the covered bond sector or are market conditions sufficiently improved that they will shy away from this funding route?

 Opinions vary widely as to the potential size of the market and the timing of future issuance but there is a pervasive belief that covered bonds have a role to play in emerging markets.

 "They are the next frontier," says Andrea Montanari, head of covered bonds structuring at UBS.

Growing global market

 Ted Lord, head of covered bonds at Barclays Capital, says that a lot of potential covered bond transactions are currently being discussed and that the Kookmin deal is a continuation of a process towards a global covered bond market.

 "There will always be a debate about pricing on an inaugural [issue] but the point is there is a basic need for covered bonds. In Asia, for example, countries are looking to promote home-ownership and they have huge infrastructure plans. Financing through covered bonds fits neatly into this space," he says.

 Governments and regulators are certainly keen on the sector. The World Bank is said to have been deluged with requests about it from countries across the emerging markets - central and south-east Asia, Central and South America, even parts of Africa. Many of these jurisdictions see covered bonds as offering an attractive route for private sector banks to raise much-needed funds in a cost-effective way.

 "There is a real need for borrowers to access efficient, term funding," says Mr Ross.

 This need is particularly acute now. Banks' balance sheets have been decimated by soaring bad debts and, just when they need it most, access to fresh funds remains restricted and securitisation markets remain extremely difficult.

 "Securitisation used to work. It was the first concept sold to emerging market issuers and investors. Now things are different," says Richard Kemmish, head of covered bond origination at Credit Suisse.

 For investors, securitisation products have been shown up as an unpredictable commodity, particularly from emerging market borrowers. Covered bonds offer far more comfort. "There are two big differences between covered bonds and securitised deals. First, covered bonds align the interests of bank issuers and investors," says Mr Kemmish. "In securitised deals, the asset risk is passed on to investors. In covered bonds, if the assets fail, the issuer loses out too."

 Moreover, banks can be more flexible with the underlying assets in a covered bond transaction. "In securitisations, you have a ring-fenced pool of assets. In covered bonds, you can put assets in and take them out as appropriate," says Mr Kemmish.

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Will Ross, head of HSBC's financing solutions group in Asia-Pacific

Risk awareness These differences are highly relevant. Having seen the collapse of securitised assets, investors are far more aware of the need to manage, control and minimise risk. This new focus is unlikely to disappear any time in the short term and it has prompted another, subtle change in investor behaviour. "Diversification used to be what every asset manager strove for. Now there is a much more emotional response to deals. Investors are focusing on borrowers with whom they have a strong sense of affinity. They are most comfortable with the names they know best," says Mr Ross.

 In other words, local investors are keen to invest in local names, banks they know and understand. "The Kookmin deal was built around Asian investors. Then it moved to Europe and the US," says Mr Porter.

 Other issuers are said to be waiting in the wings, including the Korean Housing Finance Corporation. Outside South Korea too, meetings are taking place with regulators, treasurers and finance ministries.

 "We are in active discussions with potential issuers in Brazil and South Africa, as well as Asia," says one head of origination.

 Such discussions take time. Covered bonds are highly regulated and often the rules surrounding them are enshrined in national legislation. While this makes them a particularly safe form of investment, it also means that governments and regulators have to have confidence in the concept - and issuers have to be prepared to put aside the time to cover off the logistical, legal and regulatory requirements.

 They are most likely to find the time if the pricing makes sense.

 "Many banks may want to use the assets on their balance sheet to achieve more efficient pricings via an alternative asset class," says Mr Au.

 Mr Kemmish adds: "Normally, the average difference between unsecured bonds and covered bonds is two and a half times so every 2.5bps of spread on an unsecured deal comes down to 1bp with a covered deal. Two years ago, spreads were so tight that this didn't matter terribly. Now there can be hundreds of basis points of difference."

Logistics challenges

 This is clearly attractive. But challenges remain, not least having the technology and logistics in place to cope with the documentation and processes around covered bonds. In addition, some emerging markets remain off the radar.

 Emerging markets where the sovereign is better rated - such as south-east Asia - are much more attractive to investors.

 "Although covered bonds can be more highly rated than sovereign borrowers, investors may still feel more instinctively comfortable with sovereign paper than bank paper. There is also a bit of a dichotomy. Investors may want covered bonds to be priced above their respective government because they are not government guaranteed. Conversely, issuers may feel they should be able to get away with very tight terms because they are using some of their best assets as collateral," says UBS's Mr Montanari.

 So covered bonds incite debate for both issuers and investors. In times of extreme uncertainty, the asset class comes into its own; when the environment is less explosive, the bonds lose some of their lustre.

 "Whether or not this is going to be a frequently used channel depends on market conditions and other funding possibilities," says Mr Au.

 When the Kookmin deal was first mooted, a flood of issuance was predicted, which now seems unlikely. But regulators are keen to see banks behaving more responsibly; governments are keen to reduce the sector's reliance on guarantees; emerging markets need to fund infrastructure and property development and emerging market investors are attracted to 'safer' products and local names. Covered bonds may not be a panacea - but they are likely to become an increasing feature of the emerging markets landscape.


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