RBC’s Historic Covered Bonds

RBC-MortgageThe rate you pay on your mortgage largely depends on what it costs your lender to raise capital. That’s why RBC’s latest covered bond issuance is noteworthy.

RBC issued $2.5 billion worth of covered bonds on September 12.

(Covered bonds are bonds backed by both the issuer’s credit and a pool of mortgages, in this case RBC’s mortgages. If the lender/issuer goes under, investors can still rely on the mortgages to get their money back. Canadian banks sell covered bonds to generate funds to lend out as mortgages.)

RBC’s issuance was the world’s first SEC-registered covered bond, meaning it could be bought by U.S. mom and pop investors for the first time. This huge pool of buyers makes the bonds easier to trade and less expensive to issue.

Why does any of this matter? It matters because these covered bonds will lower RBC’s funding costs, and the savings can theoretically be passed on to borrowers.

How much lower is hard to say. But even if it allowed RBC to price 2-3 basis points lower than otherwise, that shaves up to $354 of interest off a $250,000 mortgage over five years. Small savings, but still savings.

Some quick covered bond facts:

  • RBC’s new covered bonds are “AAA,” the best rating a bond can get.
  • Demand was high: Investors lined up for $5 billion worth, but RBC was selling just $2.5 billion.
  • Its 5-year covered bonds sold for an impressively low yield of 1.20% (just 51 basis points above “risk-free” 5-year U.S. Treasuries).
  • Most covered bonds are sold privately to big institutional investors (i.e., via “private placements”).
  • A reported 180-200 investors bought into this latest deal, versus normal covered bond issuances which draw about 50 or so.
  • Canadian banks are allowed to issue covered bonds equalling up to 4% of their assets.
  • RBC reportedly worked about two years to get the SEC’s blessing for its new covered bonds.
  • Of the 110,698 mortgages used as collateral in RBC’s covered bond program as of August 31:
    • Only 434 were delinquent.
    • The average drawn loan-to-value was 61.46%.
    • Only 3.7% had non-prime credit scores (i.e., scores under 600).
    • 59.76% had fixed rates. The rest were variable.
  • [ File # csp0156170, License # 1274184 ]<br /> Licensed through http://www.canstockphoto.com in accordance with the End User License Agreement (http://www.canstockphoto.com/legal.php)<br /> (c) Can Stock Photo Inc. / webkingOn a fair value basis, RBC’s SEC-registered covered bonds have traded less than 5 bps above traditional covered bonds (which rely on mortgage collateral insured by CMHC). That’s a surprisingly tight spread given that insured mortgages entail less risk.)
  • According to a dealer source, this issuance traded about a quarter percentage point less than RBC would have paid to issue regular bonds (a.k.a. subordinated debt). Issuing at that price point would save RBC $25-30 million on a $2.5 billion 5-year issue.
  • Funding through Canada Mortgage Bonds (CMBs) is still cheaper than covereds, but banks are limited to how many CMBs they can issue.
  • RBC can reportedly issue an additional $9.5 billion more worth of U.S. covered bonds with its current SEC approval (“shelf registration”).
  • Roughly 14% of RBC’s outstanding uninsured mortgages are used as collateral in its covered bond program according to Q3 2012 DBRS data.
  • No covered bond has ever defaulted.

Earlier this year, the government announced new covered bond rules, one of which bans banks from using insured mortgages as collateral in covered bonds. That’s derailed most banks’ covered bond programs until 2013, raising their capital costs in the process. This RBC issuance was the first covered bond from a Canadian bank in months.

Going forward, other banks could also tap the U.S. public markets and sell SEC-registered covered bonds. But it’s not an easy process.

Fortunately for others, RBC’s issuance has set a precedent. In the future, that should pave the way for more efficient SEC approvals and slightly lower funding costs at the Big 6 banks.


Rob McLister, CMT

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