Covered bonds finding their feet in Asia

A slow trickle of deals suggests there is appetite for covered bonds in Asia. But there are also signs that growth will be slow.

After seven years of stop-start development, Asia’s covered bond market finally appears to be gathering steam.

South Korea’s Kookmin Bank opened the market in 2009, selling a $1 billion deal backed by pool of domestic mortgages. But although the deal caught the attention of funding officials across the region, leading to a flurry of pitch meetings with deal bankers, it was not until 2015 that the market took shape.

Singaporean banks deserve much of the credit. DBS reopened a market that had been dormant for two years in July 2015, when it raised $1 billion from a US dollar-denominated deal. UOB, a local rival, sold the first euro covered bond from an Asian bank in March 2016 — creating a funding avenue that DBS and, most recently, OCBC have both followed.

These bonds certainly offer funding diversification to issuers. European covered bond investors are famously stringent, leaving them off limits to those Asian issuers sticking to plain vanilla bond formats. Hong Nam Yeong, DBS’s head of wholesale funding, told FinanceAsia that his bank’s euro covered bond “afforded us access to the world’s deepest and most established investor base for the asset class”. 

But although it is now abundantly clear Asian banks can tap the European covered bond market, it is less clear how often they will. There is reason to think covered bonds in the region will remain, at least for now, something of a sideshow.

European volumes down

In many ways, it is a perfect time for Asian issuers to tap the covered bond market. Specialist investors have seen the volume of euro covered bond issuance plummet, from €215.3 billion ($227.8 billion) in 2011 to €138.4 billion last year. And although the European Central Bank’s huge purchases of covered bonds have reduced pricing for issuers, that has not helped other investors.

Covered bonds are debt issues backed by a ring-fenced pool of assets — typically, though not always, mortgages — that offer investors recourse both to the assets and the issuer itself. Invented in 18th Century Prussia, the structure for years remained a strictly European phenomenon. But as European volumes dipped, Asian issuers seized their chance.

Singapore's three biggest banks have also issued euro covered bonds this year. DBS turned to the market in January, raising €750 million from a seven-year deal. The bulk of demand came from first-time investors to DBS, and European accounts represented more than two thirds of the entire allocation.  The deal was entirely backed by Singapore-dollar- denominated residential property mortgages, although the structure included hedges to reduce the currency risk.

Less than a month later, UOB pulled off another first, selling the first dual-currency covered bond from an Asian issuer. Lee Wai Fai, group chief financial officer at UOB, told FinanceAsia the success of the deal “reinforced our commitment to the euro covered bond market as a regular issuer,” arguing that both tranches “maximised” investor access and diversification.

To complete the triptych, Singapore’s other ‘big three’ bank, Oversea-Chinese Banking Corp, raised €500 million from its own deal in the middle of March. Alongside occasional deals from Kookmin, and regular issuance from Korea Housing Finance Corp, it is clear that Asia’s covered bond market is now in the best shape it has ever been in.

But there are clear hurdles to the widespread adoption of covered bonds, including the need for local regulators to take a smart approach to the structure.

Law and order

It should come as little surprise that Singapore and South Korea are the countries leading the charge for Asian covered bonds. The two are the only countries in the region where regulators have put in serious work to put a covered bond framework in place, making it much easier for deals to be structured. 

South Korea introduced covered bond laws at the end of 2013, attempting to encourage domestic lenders to increase their proportion of long-term fixed-rate mortgages in the domestic market instead of relying on shorter tenor floating rate loans.   

Singapore set rules for international covered bonds around the same, although the first deal took place almost two years later — DBS’s $1 billion three-year covered bond in July 2015.

Legislation appears a crucial motivation for banks who, in truth, are not desperate for alternative sources of funding.

“The impetus for Asian banks to do covered bonds is pretty low,” Ben McCarthy, head of Asia Pacific structured finance at Fitch, told FinanceAsia in an interview. “The market remains regulatory driven” 

Indeed, there is an argument that covered bonds in Asia are a solution without a problem. Mortgage lending accounts for a lower percentage of total loans for many Asian banks than their European counterparts, according to Tim Fang, Asia head of FIG debt capital markets and capital solutions at UBS. This means covered bonds are not of automatic benefit even to banks lucky enough to have received the help of savvy regulators.

This is particularly true in China, which was the source of a unique covered bond in November: a $500 million green covered bond from Bank of China. That deal ring-fenced assets less stringently than typical covered bonds, something that securitisation bankers argue will likely be common for future issuance from China. But many banks may not choose to follow since it is corporate loans, rather than mortgages, they are eager to move off their balance sheets.

“Chinese banks, in particular, have relatively high exposure to corporate lending which cannot be used for covered bonds under the traditional definition,” Fang said. 

This certainly does not mean covered bonds won’t bloom in years ahead. Banks from countries across the region may well decide to win bragging rights by selling their countries’ first covered bonds. Frequent borrowers such as DBS will welcome the diversification benefits.

But if covered bonds in Asia are really to take off, it is not going to be because issuers need the format. It will, instead, be because investors demand it.

As Fang, who helped manage UOB’s $1.2 billion dual-tranche covered bond in February, put it: “The speed of this growth will depend on the receptiveness of Asian and international investors to the new format.”

 

This is an updated version of a covered bond feature from our March/April issue. This story corrects an error in the print edition, which identified DBS as the first Singaporean bank to issue a euro covered bond. It was, in fact, UOB.

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