Resiliency of Canadian Covered Bonds
In the current world of sharply rising interest rates and a possible recession, questions have arisen about the resiliency of the cover pools for Canadian covered bonds. Additional focus is brought to this question by the declining housing values in Canada — Vancouver and Toronto in particular have seen reported 15 to 20 per cent declines in house prices from recent peaks.
Canadian covered bonds take their strength from several factors, not the least of which is the conservative nature of property investors in Canada, combined with fairly strict underwriting standards set by OSFI. This has resulted historically in a typical annual loss rate for residential mortgage pools for most banks in basis points in the single-digit or low double-digit range.
This low loss experience is supported by the full recourse nature of Canadian mortgage loans. A mortgagor under Canadian law is personally liable for full payment of the mortgage loan if the loan is foreclosed on and liquidated at a loss. Unlike the case in many U.S. States, a Canadian property owner cannot turn over the keys to house and walk away free of the debt.
Another protection for Canadian cover pools is the monthly Asset Coverage Test that each program must pass. If the value of eligible mortgage loans in the cover pool does not exceed the outstanding amount of covered bonds by the required overcollateralization amount, the test is failed. Defaulted mortgage loans are not included in test. If the test is failed, the issuing bank is required to transfer additional, non-defaulted eligible mortgage loans to the cover pool. Thus, the cover pool is constantly refreshed with performing mortgage loans protecting the value of collateral backing the covered bonds.
More protection is provided by the requirement that an eligible mortgage loan for Canadian cover pools must have a loan to value ratio not exceeding 80%, measured each month based on an index of current property values in the location of the property. If the loan to value ratio exceeds 80% at any time, only only the portion of the loan not exceeding 80% of the value of the property is included in the cover pool for the calculation. This means that the value of the cover pool is protected from declining property values.
Moreover, the typical average loan to value ratio of mortgage loans in cover pools for Canadian covered bonds is between 50% and 60%, which provides a substantial buffer before loan amounts are reduced in the cover pool because they fail the loan to value maximum for eligibility. Statistical information on cover pools is available in the monthly report provided to investors by each of the Canadian banks.
Lastly, in addition to strong cover pools, investors in Canadian covered bonds hold exposures to banks that operate in a conservative banking environment. Canadian banks came through the financial crisis of 2008 in excellent shape and continue to be highly regarded in international capital markets. Banking regulation in Canada contributes to the conservative environment with a with a regulatory approach that prioritizes stability. The recent tightening of mortgage loan underwriting evidences this caution.
This collection of protections is what supports the perception of quasi-sovereign risk for Canadian covered bonds.
Stellar Year for Canadian Covered Bonds
A Smashing Year for the Canadians
2022 was a remarkable year for Canadian covered bond issuers. The Canadians issued 68 series of covered bonds in 2022 for an equivalent total of C$100,515 million, more than doubling the 30 offerings of 2021. There were 58 offerings in 2020, but 25 of those were retained offerings for repo with the central bank, so don’t count as public offerings.
In 2021, the Canadians were 20 per cent of the global market in covered bond issuance. While the final numbers for 2022 are not yet available, with 68 offerings it is likely that the Canadian banks have not slipped from that position.
In 2022, the Canadians issued in six different currencies: USD, A$, C$, CHF, £, and €. Euro was the most popular currency, with 29 offerings for €32,368 million, followed by the USD with 14 offerings for $24,705 million. RBC was the most active issuer with 18 offerings, followed by BNS with 14 offerings.
Some of the motivation for issuance likely was replacing funding obtained at the beginning of the pandemic from the Canadian central bank in 2020, when about C$90,000 million of covered bonds was taken to the central bank by the Canadian banks. Most of those loans from the central bank were two-year loans.
The elevated Canadian covered bond issuance was also responsible in large part for the largest U.S. dollar covered bond issuance since 2012. With a total U.S. dollar covered bond issuance of $32,500 million in 20 offerings in 2022, the Canadian banks accounted for $24,705 million in 14 offerings, well above their typical 50% of the market.
In 2023, Canadian banks have 43 series of covered bonds maturing, 16 of which are in euros and 13 in Canadian dollars. Of the maturing Canadian dollar series, ten of the series, representing C$33,500 million, were retained covered bonds transferred by repo to the central bank. With so many series maturing next year, it likely that 2023 is going to be another very active year for Canadian banks in covered bonds.
1Q22 – A Blistering Pace in 1st Quarter
A Blistering Pace in 1Q22
It was a notable first quarter for Canadian covered bond issuers: 19 issuances across dollars, sterling and euros [see the table below]. All six of the major Canadian banks issued bonds. On a Canadian dollar equivalence basis, the banks issued C$38.7 billion. Continuing a trend set last year, the Canadians represented 20% of covered bond offerings for the quarter — punching well above their weight.
This activity is probably partly attributable to the heavy retained issuance by the banks at the start of the pandemic in March and April 2020, when nearly C$90 billion was taken to the central bank for funding. This was the inaugural covered bond repo program by the central bank. Issuance limits were temporarily increased at the time to support the central bank program and provide enhanced liquidity to the banks. Most of those covered bonds had two year maturities and are running off this year.
| Pricing | Issuer | Series | Cur. | (mm) | Coupon | Maturity | Tenor | Spread | Type |
|---|---|---|---|---|---|---|---|---|---|
| 2022-03-30 | National Bank of Canada | CBL18 | $ | 1250 | 2.900 | 2027-04-06 | 5yr | +65 | 144A |
| 2022-03-29 | Bank of Montreal | CBL28 | € | 1750 | 1.000 | 2027-04-05 | 5yr | +8 | Reg S |
| 2022-03-17 | Toronto-Dominion Bank | CBL34 | € | 2500 | 0.864 | 2027-03-24 | 5yr | +11 | Reg S |
| 2022-03-17 | Royal Bank of Canada | CB69 | € | 150 | 1.296 | 2037-03-24 | 15yr | +15 | Reg S |
| 2022-03-17 | Royal Bank of Canada | CB70 | $ | 1500 | 2.600 | 2027-03-24 | 5yr | +65 | 144A |
| 2022-03-15 | Royal Bank of Canada | CB68 | € | 2000 | 0.625 | 2026-03-25 | 4yr | +9 | Reg S |
| 2022-03-08 | Bank of Nova Scotia | CBL42 | € | 2000 | 0.450 | 2026-03-16 | 5yr | +10 | Reg S |
| 2022-03-03 | CIBC | CBL40 | $ | 100 | SOFR+45 | 2025-03-10 | 3yr | +45 | 144A |
| 2022-03-03 | CIBC | CBL39 | € | 2500 | 0.375 | 2026-03-10 | 4yr | +6 | Reg S |
| 2022-03-02 | Bank of Nova Scotia | CBL41 | $ | 2250 | 2.170 | 2027-03-09 | 5yr | +58 | 144A |
| 2022-03-02 | Bank of Montreal | CBL27 | £ | 600 | SONIA+40 | 2027-03-09 | 5yr | +40 | Reg S |
| 2022-02-02 | Bank of Nova Scotia | CBL36-2 | € | 100 | 0.623 | 2041-10-15 | 20yr | +16 | Reg S |
| 2022-02-01 | FCDQ | CBL14 | € | 750 | 0.250 | 2027-02-08 | 5yr | +5 | Reg S |
| 2022-01-20 | National Bank of Canada | CBL17 | € | 1000 | 0.125 | 2027-01-27 | 5yr | +5 | Reg S |
| 2022-01-19 | Bank of Montreal | CBL26 | € | 2750 | 0.125 | 2027-01-26 | 5yr | +6 | Reg S |
| 2022-01-18 | Royal Bank of Canada | CB67 | € | 2000 | 0.125 | 2027-01-25 | 5.25yr | +6 | Reg S |
| 2022-01-17 | Bank of Nova Scotia | CBL39 | £ | 1300 | SONIA+100 | 2026-01-26 | 4yr | +28 | Reg S |
| 2022-01-17 | Bank of Nova Scotia | CBL40 | € | 1250 | 0.375 | 2030-03-26 | 8yr | +10 | Reg S |
| 2022-01-11 | CIBC | CBL38 | $ | 2500 | 1.846 | 2027-01-19 | 5yr | +48 | 144A/Reg S |
Covered Bonds – Flight to Quality
Critical Liquidity Source in Times of Stress
In the past ten days, covered bonds have shown their value in a crisis for the Canadian banks. They have issued covered bonds in Europe at least seven times in that last ten days. When senior debt and ABS is difficult to bring to market, covered bonds have a ready investor base. Covered bonds represent a flight to quality when markets are difficult. The Canadians have been so successful that they have irritated European funding officials. See the story in Global Capital.
Canadian banks survived the last financial crisis in better condition than perhaps any other OECD banking system. And the Canadian banking system, although relatively small, remains one of the preeminent banking systems in the world. The six major Canadian banks dominate the banking market in Canada. They are quite conservative. They tend to follow each other and particularly the traditional leader, Royal Bank of Canada. Compared, for example to the banking system in the United States, the Canadian banks have had remarkably few crises. It is a close-knit community and a comfortably profitable business in Canada.
When the crisis created by the coronavirus COVID-19 began to envelope the Western world, the Canadian banks moved quickly to shore up their liquidity. An important tool for accomplishing this has been covered bonds. In uncertain times, investors tend to seek sovereign paper in a flight to quality. Covered bonds provide an attractive alternative to sovereign paper. Covered bonds have a similar risk profile to sovereign bonds but generally provide better yields.
Why did the banks choose Europe to issue their bonds? Because of favorable currency swap costs. And the market proved quite receptive. Even though there were at times two or three Canadian banks in the market at same time, they all managed to issue benchmark-size offerings at favorable rates. There was clearly an investor hunger for safe assets with a decent yield and the Canadians met that need quickly. They were in and out of the market before their European competitors had even contemplated challenging the market turmoil.
And although the Canadians deserve credit for moving quickly, the moral of the story is really the value of covered bonds in stressful times. As it did during the financial crisis, the covered bond market continues to be open and available to provide critical liquidity when other finding sources are spotty or not available at all. And just to note, this is a funding tool that U.S. banks do not have access to.
PIMCO CB Fund
PIMCO starts managed covered bond ETF fund; see article in Covered Bond Report