Covered bonds are the latest financing wrinkle for Canadian financial services firms that want to reduce their borrowing costs. And in a world in which some foreign banks’ status has tumbled to suspected from respected, covered bonds make sense.

These debt instruments are fairly new in Canada. The first Canadian issue was completed by Toronto-based Royal Bank of Canada in November 2007. On a global basis, the covered-bond market, currently with US$3 trillion outstanding, has never had a default in its 240-year history, according to The Cover, a publication that covers this small niche of the global debt market.

Covered bonds, the concept of which is familiar in European markets, provide a guarantee for the bond by adding specific assets and their cash flow to back up the credit of the financial services institution that issues the covered bond. That’s different from a vanilla debenture, which just backs the bond with the credit of the issuer.

In the event of a default, a conventional debenture gives the bondholder the right to the insolvent issuer’s assets in what can turn out to be a scavenger hunt. In contrast, the covered bond identifies specific assets — usually a mortgage pool — that are designated for backing the bond.

“The covered bond is issued by the bank and stays on its books,” says Kevin Chiang, senior vice president for Canadian structured finance with DBRS Ltd. in Toronto. “So, if there is a default, the [bond-]holder has recourse, not only to the issuer but to the asset as well.”

Covered bonds are different from the far more familiar Canada mortgage bonds. CMBs are off-balance-sheet instruments, while covered bonds stay on the issuer’s balance sheet. The risk of prepayment, which reduces the potential return of the bonds, stays with the originator of the covered bonds and their underlying loans. That’s the opposite of CMBs, which make the bondholder take on prepayment risk. Also greatly important is the fact that covered bonds’ credit risk stays with the issuer — in contrast to CMBs, which assign it to a third party.

The idea of backing a debt instrument is nothing new. Off-balance-sheet structured products, such as credit card trusts, have been built on dedicated and very specific cash flows for decades. In the U.S., the idea of raising money for freight-train cars — with each bond backed by a specific piece of rolling stock — is also old hat.@page_break@What is new is that the bond’s cover — specific to each bond and part of the issuer’s capital structure rather than hived off to an entity supposedly unrelated to the issuer — gives potential bondholders more security. The cover raises the bond’s rating to AAA from the lower ratings on most bank debt. This means the issuer can pay a little less interest for any term.

Covered bonds should, therefore, have tighter spreads over federal debt than even mortgage-backed securities, which are similar in concept.

A handful of covered bonds are outstanding, such as RBC’s 3.72% issue, due Nov. 10, 2014, and its 3.18% issue, due March 16, 2015. Both have AAA ratings — and rank at least as high as RBC’s senior deposit notes.

But the question for the potential buyer of what are usually mid-term notes from solid Canadian banks is: “Why bother?”

Skeptics may question the value of the additional security provided by specific asset coverage. The doubters argue that if a major Canadian bank did approach insolvency, the federal government would probably arrange a rescue package with the aid of other banks or the Bank of Canada. Therefore, why accept a lower interest rate for what amounts to protection against an event that is extremely unlikely to happen?

Those doubts have not impaired the market for covered bonds, though, Chiang says. As of this past July, all of Canada’s Big Five banks had issued covered bonds, all rated AAA.

Canadian issuers are selling covered bonds both to European (mainly) buyers fearful of bank collapses and to Canadian and American investors who just like the idea of enhanced security, Chiang notes. Sales of Canadian banks’ covered bonds are rising in Europe because of the troubles financial services institutions face in that region; investors in one European country worry about bank failure in another.

That is, in fact, what lies beneath the concept of the cover: what is close tends to be familiar; what is distant is less so. But foreign investors take comfort from the fact that the assets on which they lend are still on the books of the bond issuer and have has not been dumped into the securitization market.

The final thing to consider is liquidity, which translates as spreads in the secondary market when bondholders want to cash out.

“Liquidity matters when I need it,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Man-agement Ltd. in Halifax. “If you compare the covered bond with the deposit note, there is less liquidity in the covered bond. But if the covered-bond market develops in Canada, then it should become more liquid. And covered bonds would be more attractive for those who need that liquidity.”
IE