Canadian banks issued a record number of covered bonds in March and April, raising nearly $100-billion from international debt markets and Bank of Canada liquidity programs in order to manage rapidly changing funding needs.
With clients drawing on lines of credit and deferring loan payments, Canadian banks turned to issuing covered bonds, a type of debt security backed by high-quality assets, such as residential mortgages, to access liquidity.
Over the past two months, eight Canadian banks collectively issued 38 covered bonds, surpassing previous annual records. By comparison, 24 covered bonds were sold in all of 2019.
"From the Canadian bank perspective, the interest in covered bonds has just exploded,” said Jerry Marlatt, a partner with U.S. law firm Mayer Brown, who specializes in covered bonds.
The ability of Canadian banks to tap debt markets as investors fled everything but the safest assets speaks to the quality of the collateral backing of Canadian covered bonds, Mr. Marlatt said. At the same time, the scale of the additional fundraising shows how strained liquidity became as the COVID-19 pandemic hit financial markets.
The biggest driver of issuance was a Bank of Canada policy change in mid-March that made covered bonds eligible for the central bank’s term repo program. Repo facilities provide cheap liquidity to banks by letting them sell non-liquid assets to the Bank of Canada with an agreement to buy them back later.
Around $50-billion worth of covered bonds were issued in March alone for the purpose of repo operations.
Canadian issuers also looked to international markets, selling around $9.7-billion worth of foreign denominated covered bonds in March and $12-billion in April, according to DBRS Morningstar data. Canadian banks were among the most active issuers in the world, Mr. Marlatt said, selling bonds denominated in euros, U.S. dollars, Swiss francs and Australian dollars.
“The Canadian banks came out of the 2007 and 2008 crisis probably in the best shape of any banking system in the world, and it shows up in the marketplace where investors look upon their securities favorably, particularly covered bonds,” Mr. Marlatt said.
“Early in this period, they were issuing a lot of covered bonds in Europe, and that created some antagonism in Europe about how the Canadian banks were taking all the liquidity out of the market. ... But their bonds were being really welcomed by investors,” he added.
For the banks themselves, covered bonds provided comparatively well-priced funding as debt markets seized up in March and the cost of funds soared.
Covered bonds are typically considered the safest debt a bank can issue. If a bank defaults on its debt payments, investors have recourse to the “covered” pool of assets that was pledged as collateral.
That additional safety meant investors remained interested in covered bonds as they turned away from riskier debt, said Marty Halpin, HSBC Bank Canada’s head of balance sheet management. The cost of issuing covered bonds did increase, but not as much as for unsecured debt.
“In the latter half of March, the first half of April, we saw the spreads of senior unsecured debt versus covered bonds widen out noticeably, so, from a bank funding perspective, the business case was clear that covered bonds would be the preferred way to fund in the current environment,” Mr. Halpin said.
Spreads on covered bonds have also come down in recent weeks, he added: “We’re still wider of where we were in the early part of this year, but we are materially tighter than where we were five to six weeks ago."
There is a limit on the amount of covered bonds that banks can issue. Regulators cap the percentage of assets a bank can use as collateral to ensure it hasn’t walled off too many of its premium assets in the event of insolvency.
The Office of the Superintendent of Financial Institutions raised this cap in March to 10 per cent from 5.5 per cent, although only for covered bonds issued for the purpose of repo operations. That change added at least $225-billion in extra room for covered bond issuance, according to DBRS.
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