Image: Thinkstock
Image: Thinkstock

The introduction of a legal framework for covered bonds in Canada has undoubtedly broadened the appeal of these securities, which are backed by both the credit of the bank issuing them and a pool of mortgages on the bank's balance sheet.

Already ultra-safe, in the sense that they have a dual guarantee, Canadian covered bonds now benefit from increased disclosure about the mortgages behind them and more certainty about recourse to the cover pool in the event of a default.

But so far, this broader appeal hasn't resulted in increased issuance. For one thing, the covered bond issuance limit of 4% of total assets, which was put in place in June 2007 by the Office of the Superintendent of Financial Institutions, Canada's bank regulator, is unchanged. Add into the mix a new restriction that prohibits banks from using insured mortgages as collateral, and what you get is a market that has been slow to restart.

So far, only four of the seven banks that issued covered bonds before the legal framework was adopted in 2012 have registered new programs with the Canada Mortgage and Housing Corp. (CMHC), the country's national housing agency.

DBRS calculates that in the first 11 months of 2013, just $11.8 billion (Canadian dollar equivalent) of Canadian covered bonds was issued; this is a decline of $3.8 billion year-over-year.

Investors have been looking to Canada and other markets to help offset a drop in issuance of covered bond by European banks. Legal frameworks are also being introduced in South Korea, Panama, Mexico, Morocco, New Zealand, Singapore and possibly the United States. But Canada's experience suggests that there may be limits to the expansion of this market.

Covered bonds have existed in Europe since 1769. Denmark is the biggest issuer of mortgage-backed covered bonds; Germany and France are also large issuers. But a combination of deleveraging by European banks , improved access to unsecured funding and a desire to preserve assets for cheap funding from the European Central Bank have all made issuing covered bond less attractive for the region's financial institutions.

At the same time, demand for covered bonds, particularly from bank Treasuries, has been growing, resulting in ever tighter spreads for issuers. Much of the appeal is regulatory in nature: covered bonds will be exempt from European rules requiring bondholders to help absorb bank losses. They may also be classified as Level 1 assets under Basel III's Liquidity Coverage Ratio.

Canada's market is comparatively young: it dates back just seven years, to 2007. But in that short period, covered bonds have become an important source of funding for large Canadian banks.

According to figures reported by Bank of America Merrill Lynch (BofAML), there are C$63 billion ($56.9 billion) in covered bonds outstanding. (This number does not incorporate deals issued in the past six months under the new legal framework.)

However, only the Canadian Imperial Bank of Commerce (CIBC), the National Bank of Canada and the Royal Bank of Canada (RBC) have registered covered bond programs with the CMHC and issued covered bonds under the new legislation. Two others, Caisse Centrale Desjardins du Quebec (January 2014) and Bank of Nova Scotia (July 2013) have registered programs with the CMHC but have yet to bring a deal to market; and two more that were regular issuers in the past, Toronto-Dominion Bank and Bank of Montreal, have yet to register new covered bond programs.

"We were hoping everyone would have been on board six to nine months ago and issuing strongly into all markets, both in the U.S. and Europe," said Riz Sheikh, Barclays' head of covered bond structuring, Americas.

Sheikh said that one reason it has taken Canadian banks longer than anticipated to bring deals to market is that the registration process has been a lengthy one. "The CMHC is taking it all very seriously and reviewing programs in detail, making sure they work from an investor perspective, including compliance with disclosure requirements," he said.

From an investor perspective, the legislative framework is good because the regulator is taking an active role and making sure that high standards are being applied to issuance from Canadian banks. Issuers disclose detailed cover pool data, comply with a comprehensive set of tests to protect against credit risks and employ an independent asset monitor to oversee compliance with collateral requirements.

Anne Caris, research analysts at BofAML, explained that for the new programs, "the recovery analysis performed by rating agencies confirmed the overall sound quality of Canadian uninsured residential mortgage pools."

She said that, "while the expected losses are well above the ones estimated for CIBC's 'structured' [legacy] covered bond program for example, they remain moderate and compare well with peers — especially Australian, French (home loan programs), Norwegian, Swedish and Swiss issuers."

And this arguably incremental increase in safety comes at a big expense, at least for issuers, which are saddled with prohibitive costs and time constraints.

However, Jean-Sébastien Gagné, director of securitization at the National Bank of Canada, said that the biggest change wrought by the legislation is that it prohibits the use of CMHC insured loans into the covered pool. "In fact, following the new legislation, even before the establishment of National Bank of Canada's new legislative program, the bank couldn't even use our legacy structured program since it was composed of CMHC-insured loans," said Gagné. "It's really the intent of the law that issuers use only legislative programs without any insured loans."

Other say limiting collateral for covered bonds to uninsured mortgages will not have such a big impact on covered bond volumes. That's because Canada's big banks have enough uninsured mortgages on their balance sheets to sustain issuance going forward. A bigger limitation, and one that has been in place since 2007, is that Canadian banks can use no more than 4% of assets as collateral — the strictest such limit across covered bond markets.

Nevertheless, Sheikh at Barclays expects that over the coming two to three months the remaining issuers will start coming online.

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