Monday, May 4, 2009

All eyes on a covered bond first

Posted in the Financial Times by Lindsay Whip:

Kookmin Bank, South Korea’s largest, is likely to be the first Asian institution to sell a covered bond, and both investors and potential issuers will be watching closely to see how well this new product for the region is received.

Covered bonds are considered safer than conventional corporate bonds because they are backed by collateral such as residential mortgages, to which creditors get preferential claim in the event of a bankruptcy.

The collateral backing, depending on the type and quality, means institutions can issue the bonds at a higher rating than they have been assigned, and as a result can expect tighter spreads than issuing a straight corporate bond.

The bonds have been popular in Europe, although the financial crisis has taken its toll on the market, just like other credit markets.

After the collapse of Lehman there was a dearth of issuance until the beginning of 2009. Now there are signs of stabilisation, though the market is down considerably from last year, analysts say.

Thomson Reuters’ data shows global covered bond issuance has dropped by three-quarters this year.

“For Asia of course, it may not be bad timing coming in now with the market stabilising, though that depends on how long this stabilisation will prevail,” says Heiko Langer, senior covered bond analyst at BNP Paribas. “It’s going to be quite critical to see which investor base Kookmin is going to target with this transaction.”

Institutions in Asia have yet to take advantage of the covered bond market. There would have been a number of transactions, potentially from more than one country in the region, had the financial crisis not intervened, says Mr Langer.

Last year, Japan’s Shinsei Bank twice made plans to issue a covered bond, but decided against the sale due to market conditions and “internal considerations,” the bank says.

Kookmin is marketing three- and five-year covered bonds backed by residential mortgage loans and credit card receivables. The size of the sale has yet to be decided, though analysts estimate it is likely to be at least $500m (£335m, €376m).

Not only would such a sale be a first for an Asian company, it would also be the first time that an institution uses credit card receivables as collateral, according to Mr Langer.

“Until now it has been residential or commercial mortgage loans, public sector debt such as municipal debt, or some ship mortgage loans,” says Mr Langer. “Maybe if they’re going to go ahead with that it may push [the bond] further into the field of the typical credit or even ABS [asset backed securities] investor. However, these investors typically expect higher yield pick-up.”

In Europe, investors in covered bonds tend to be ratings-focused investors rather than credit-focused investors. This is because, if the latter trusts the issuing institution’s stability, it will prefer the higher yield that a normal corporate bond will give them over a covered bond with a higher rating.

Moody’s said in a report published in February: “The slowdown in Korean structured finance is likely to be enduring and drag into the first half of 2009. Traditional ABS and RMBS [residential mortgage-backed security] issuance is likely to shrink due to weak investor sentiment in the global market. Some Korean banks are showing interest in covered bond issuances as an alternative funding source.”

In the case of Japan, Standard & Poor’s is less optimistic about the potential for the market.

“We presume the Japanese banks do not have much incentive to issue covered bonds at the moment,” says Kiyoko Ohora, an analyst at S&P. “There is no specific ‘covered bond law’ in Japan, and therefore the covered bond transactions must be carefully structured.”

She adds: “The Japanese banks enjoy abundant low-cost funding through retail deposits.”

Diam, one of Japan’s largest fund managers, says creating a sufficiently liquid covered bond market in Japan remains difficult while there is no legal structure in place, without which creating a liquid market is not possible. A further difficulty is that mortgages are not widely used as collateral, as the mortgage-backed securities market in Japan is less developed than those of the US and Europe. Instead, the MBS market would probably need to develop first.

Municipal bonds are an alternative form of collateral, but Diam points to potential problems here as well.

While Japan boasts a large municipal bond market, many of the bonds issued by small rural towns or cities are not rated. In addition, the holders are mainly regional banks, which hold the bonds issued by municipalities where they are based. This means the collateral of a covered bond issued by a regional bank would be the municipal bonds of the local town, which some investors may not view as a viableform of collateral, says Diam.

“There will be a market in Asia but it will take time to develop and to educate the investor base,” says Mr Langer. “New entrants who came to this market had to go through that in the past. Between 2004 and 2007 it was particularly easy to expand and now it’s particularly difficult. But it’s not impossible.”

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