Covered bonds are to be offered to US retail and secondary investors for the first time, following a Securities & Exchange Commission (SEC) no-action letter sent to Royal Bank of Canada (RBC) on May 18.
RBC’s $12 billion cross-border covered bond offering are the first to be registered with the SEC, under the US Securities Act. They are also distinctive in using as collateral underlying mortgages which are not insured by Canada Mortgage and Housing Corporation (CMHC) unlike covered bonds issued by most other banks.
Covered bond issuances are carried out on a contractual basis in Canada, with banks selling underlying mortgage loans to a subsidiary special purpose vehicle (SPV) that guarantees the bonds. Both the guarantee and the bond have to be registered with the SEC under the Securities Act, making it difficult to rely on shelf registration as a foreign private issuer under form F-3.
A Canadian bank that has issued securities in the US can qualify for shelf registration but an SPV guarantor cannot because it is not a wholly-owned subsidiary of the bank and has not been reporting annual and quarterly reports with the SEC under form F-1. This is why a no-action letter was needed.
Issuers were initially put off by the amount of time and expense involved in getting a no-action letter, with a lot of uncertainty as to whether or not it would be successful.
But Lawton Camp, a partner with Allen & Overy who acted for the underwriters, said RBC was willing to put in the time to get it done.
Jerry Marlatt, a partner with Morrison & Foerster who represented RBC in the registration of the securities said selling covered bonds was similar to selling medium term notes. “You take advantage of market opportunities and you come to market as quickly as you can,” he said.
The SEC allowed shelf registration for the guarantor under the condition that the guarantor provide monthly reports to investors and annual reports to the SEC. While the disclosure requirements are similar to those of asset backed securities under regulation AB, the SEC made it clear the covered bonds are not to be considered asset backed securities.
“The SEC took the view that a covered bond is a package of a bond and a guarantee that was half way in between a corporate bond and an asset backed security,” Marlatt said. “What they’ve done is try to put together a set of disclosure guidelines that cover this hybrid kind of security.”
The cover pool of mortgage loans acts as the covered bond collateral and secures the SPV’s guarantee. This means covered bond investors are not subject to default risk on the mortgages.
“That’s why it’s not like asset backed securities,” Marlatt said. “Collections on the mortgage loans don’t go to pay investors; instead the collections are used to buy new mortgage loans to replace the ones they are paying down.”
It is hoped the deal will prompt more Canadian covered bond issuances.
Camp believed issuers that currently file on form F-3 would be the first movers. “If the market starts to move towards having a clear prejudice for those deals that are registered, I expect others will feel the need to follow,” he said.
There is not yet a legislative framework governing Canadian covered bond issuances. But Canadian Parliament recent proposed a legal framework for covered bonds, which would also restrict the use of insured mortgages as collateral. If enacted, Canadian banks will have to set up new covered bond programs. Excess demand and a flurry of bank exits could follow.
Canadian banks are therefore expected to view this offering as a model in the use of uninsured mortgages as underlying asset.
“It is expected that in Canada most of the CMHC insured programs will go into wind-down mode,” Camp said. “New programs will be established with assets that are not CMHC insured.”
Until now all covered bond offerings in the US have relied on a registration exemption under Rule 144a of the Securities Act. Rule 144a covered bonds can only be sold to qualified institutional buyers.
Marlatt said the market for covered bonds in the US issued under rule 144A is beginning to tap out because there are only so many qualified institutional investors and some of them have a limited capacity to buy unregistered 144A securities.
“It’s a lot of work, a lot of time and dedication. It makes less sense when the market is just starting. The more mature the market gets the more sense it makes [to register covered bonds with the SEC.]”