Introduction: Here to stay

The secured debt security provides lenders with a cost-efficient and long-term source of funding. It offers investors quality exposure to lending institutions through credit without a state guarantee.

Banks across Europe, Canada and Australia have been large issuers, and the product is fast gaining popularity among US banks. The Royal Bank of Canada $12 billion issuance in June was the first to tap US retail and secondary investors.

IFLR spoke with Goldman Sachs' head of covered bond origination, Eldar Mezbur, to hear his views on growth opportunities and obstacles in the market.

How would you explain the growth in covered bonds?

Covered bonds are an old product with more than 240 years of history and no default. In reality the growth came with the unification of Europe and specifically with the introduction of the euro in 1999. This is when this essentially German product started to migrate into the rest of Europe and ultimately into US and Canada.

And now it's heading into Asia. As countries either created covered bond legislation or adopted/amended existing frameworks, we have seen issuers realise that there is a cheaper way of funding their assets.

In my view, all the legislative frameworks for covered bonds are strong. They are based on the German pfandbriefe - that is essentially the 'mother' legislation. Other countries may have tweaked this framework but it is essentially a bond with dual recourse. This is what investors are buying into. And unlike the asset-backed securitisation world, you don't live or die based on the assets in the SPV. There is much more to it.

Lastly, the worldwide acceptance of covered bonds pre-crisis is due to a relatively good pick up over SSA. If you have a covered bond coming from a sound jurisdiction and a strong legislative format, investors may be buying them over national government bonds, with significant spread pick up.

If one looks at the number of new issuers that came out during the latest financial crisis there was an average of 18 every year. This underlines the fact that covered bonds are the funding tool of the future and are here to stay. Add to that the fact that covered bonds are to be exempt on bail-ins and you can see the reason for increase in investor base.

How has the product changed, if at all since the crisis, in terms of the quality of mortgages used or the ease of selling them??

The way of selling covered bonds has changed dramatically. In 2003, when I started in the covered bond space (prior to this I was in ABS) investors would view covered bonds as AAA-rated rates product. Now some covered bonds have migrated from rates to credit products, still maintaining rates status in stronger jurisdictions' to be clear.

One thing is for sure, when we have issuer-investor meetings these days, more and more often we have credit analyst supporting PM's, predominantly looking at the following three things: the jurisdiction the issuer is coming from, the credit of the issuing institution and ultimately what is in the cover pool.

Before 2007, there were perhaps 15 basis points between the best and worst issuers. There are now around 300 basis points. That gives some indication of how things have become so much more volatile and versatile. Also, rating spectrum of covered bonds has changed dramatically, where prior to the crisis, almost all covered bonds were AAA rated, now we have covered bonds with a BBB rating.

Where are the opportunities, geographically for issuers??

Stronger jurisdictions such as the Nordics, Germany, France and UK will continue to see demand from investor base. Also issuers outside Europe such as Canadians and Australians will continue to see demand. One should not forget, Spain and Italy, where clearly windows of accessing markets are a bit more challenging in the current market environment.

When it comes to new jurisdictions we will see first true Asian covered bonds in the near future from Singaporean issuers, this will pave the way for other Asian jurisdictions. The US have issued covered bonds in the past and there are big expectations for forthcoming legislative framework. There are talks about Brazilian, Chilean, Panama and Mexican covered bonds.

How big a move do you think the SEC's relaxing of restrictions and allowing registered covered bonds to retail investors is??

I think one should remember that Royal Bank of Canada (RBC) had an unsecured programme SEC-registered, and it is filing under F3 documentation, which ultimately, after quite a lot of work enabled it to have its covered bond programme SEC-registered. (At the time of going to press the RBC had still not had it approved).

It's not clear how many other Canadian issuers will pursue this, but considering that most other Canadian issuers who have unsecured SEC-registration are filing under F9 which are not as detailed as the F3, this may present challenges when it comes to having their covered bond programmes SEC-registered. Nevertheless, it's a good precedent and it should mean that the USD covered bond investor universe will get deeper.

Are there any other markets where covered bonds legislation is expected soon??

In the US, Canada and New Zealand there is significant progress. I don't think there will be legislation in Singapore or Japan. But in some ways it doesn't matter too much, as long as the structure is sound, as investors value a solid structure more than a weak legislative framework.

What obstacles or impediments to growth do you foresee??

The encumbrance issue is potentially a big issue. Also, the origination of quality assets to be utilised in cover pools may restrain future issuance. Even looking at the UK, how many new mortgages have been granted since the crisis started? And ultimately, what effect does that have on the volumes of covered bonds? This slow down of mortgage lending applies almost everywhere globally.