Bank of China raised $500 million from a green covered bond last week, becoming the first Chinese issuer to ever use the covered bond format for funding.
In theory, the deal should open up a potentially lucrative source of business for banks — and a markedly different asset class for investors. In practice, the chances are it won’t.
The deal was by no means a failure. It generated $900 million of demand. It allowed the issuer to price inside its senior unsecured secondary curve. It has traded well in the secondary market, being quoted around reoffer on Monday.
The problem is Bank of China’s deal essentially redefined the idea of a covered bond. In its rush to try something new, the bank jettisoned much of what makes covered bonds special.
Uncovered
Perhaps the easiest way to explain covered bonds is to say that — simplistically put — they combine the protection of a conventional bond with that of a securitisation. This is evident, in particular, in the event of default.
When a bank defaults, conventional bond investors typically only have recourse to the bank itself. If that bank’s cash is not enough to pay them back, they will have to deal with losses.
In a securitisation, investors instead have recourse to a pool of assets. If the securitisation defaults and the assets do not generate enough cash to pay investors back, they will likewise have to deal with losses.
A covered bond provides the best of both worlds. It is a ‘dual-recourse’ structure, meaning investors have recourse to both the assets — also known as ‘the cover pool’ — and the issuer itself. If the issuer does not have the money to pay investors back, they turn to the asset pool, and vice versa.
It is not hard to see that this provides an additional layer of protection to conventional bond investors. But to truly shift the risk profile of a deal, investors need to be sure that the cover pool is strong — and that it cannot be used to pay back other creditors first.
This is where Bank of China’s deal falls flat.
Unlike most covered bonds, the cover pool did not consist of mortgages. It was instead a ‘bond of bonds’, as one banker put it. The cover pool comprised just 11 different bonds, the vast majority of which were sold by two Chinese issuers in the country’s interbank bond market.
That is an absurdly concentrated cover pool. It was, on the surface, an odd decision for the assets backing China’s first-ever covered bond. But Bank of China appeared set on issuing a green bond and a covered bond at the same time. The use of these ‘climate bonds’ as collateral may have provided the easiest way to do that.
The bigger problem is in the shoddy ring-fencing of the cover pool. Moody’s, the only credit agency picked to rate the deal, said there was a “weak level of asset ring-fencing protection”.
Moody's further warned that “certain preferred creditors” could receive the proceeds of any sale of the cover pool assets ahead of covered bond investors; that the security of the cover pool could be suspended; and that interest paid by the cover pool would stop accruing in the event Bank of China defaulted.
Translation: this is not really a covered bond.
The reason that covered bond investors feel so safe is that they are the ones with preferential access to the cover pool. They are not supposed to worry that “certain preferred creditors” might jump ahead of them.
Covered bonds with Chinese characteristics?
The counter-argument to this is that the nature of covered bonds is fluid and that Asian covered bonds need to develop in their own way.
It is hard to argue against the idea that Asia’s covered bond market has developed rather tangentially to the European market. It may also be the case Europe’s gun-shy investor base would not welcome Asian issuers even if they did more closely follow the old ways.
But the European covered bond market has grown so powerful because it addresses a need: providing an ultra-low-risk asset that gives investors comfort and, as a result, allows banks to slash their funding costs. Bank of China’s deal did neither.
Perhaps unsurprisingly, investors told FinanceAsia they were largely viewing the deal as equivalent to Bank of China’s senior unsecured debt. And although the deal did appear to price inside the state-owned bank’s secondary curve, the difference was minimal. It saved perhaps 5bp by turning to covered bonds — and that’s before you ignore the cost of structuring the deal.
This is a shame. The rampant development of Asia’s credit market has been the great story of the last decade, but that does not mean the hard-work is over and done with. The development of a popular, liquid covered bond market would be a boon to the region’s banks and its funds.
Bank of China, as the first mainland bank in the market, had a real chance to set a lasting template for others to follow. But instead of fighting to carve out a framework for Chinese covered bonds, the bank made do with the regulations it had: piecing together something resembling a covered bond but without the risk protection that should have enticed investors to come back again and again.
