Lifting Covered Bond Issuance Limits. It’s Time

As we like to say around here, it’s good to be a bank. Reason #188 (or whatever number we’re up to now) is covered bonds. Only seven lenders in Canada can issue covered bonds, and six of them are major banks.

Who should care about covered bonds?

Any mortgagor with at least 20% down who prefers a lower rate.

Covered bonds (CBs) are a low-cost way to raise mortgage capital, which the lender (issuer) can then lend out to borrowers. Essentially, CBs are just packaged up pools of uninsured mortgages that mega-lenders sell off to investors.

Investors like CBs because:

  • the bonds are “covered” (backed) not only by the mortgages, but with the full faith and credit of the lender itself
  • the mortgage collateral is segregated in case the bank ever goes belly up
  • the bonds are over-collateralized by about 5-10% (i.e., issuers back them with more mortgages than necessary)
  • all mortgages have at least 20% equity, resulting in small default rates
  • mortgages are generally removed from the cover pool if they’re over two months delinquent (and almost certainly if 90-days+ delinquent, due to the asset coverage test issuers must meet)
  • investors can rely on Canada’s solid CB legal framework
  • CBs are rated AAA, the highest rating possible (in fact, Fitch’s triple-A rating even factors in the risk of a 25% plunge in home prices)

All of this makes covered bonds a tasty treat to yield hungry high-quality bond investors.


Demand is off the charts in Europe, where (get this) our banks are issuing CBs at just a fraction above 0%! That’s possible because CBs are relative bargains versus European bonds, which yield near/below 0%. Bloomberg calls it a “covered bond boom,” citing a 37% ($7.2 billion) increase in Canadian issuance versus last year—a record pace.

CB sales would be even higher were it not for regulators preventing banks from issuing more than 4% of their assets in covereds. Banking regulator OSFI’s covered bond issuance limit is “extremely low compared to other developed nations,” says C.D. Howe housing watchdog Finn Poschmann. In most advanced countries there is either no limit at all, or it’s much higher (e.g., 8-10%).

Raising Canada’s 4% cap needs to be an OSFI priority. With all the regulation Ottawa has thrown at banks since the credit crisis, hiking the issuance limit is a safe way for policy-makers to loosen the noose. Doing so would pose no appreciable risk to taxpayers (the government doesn’t guarantee CBs like it does Canada Mortgage Bonds and mortgage-backed-securities). Moreover, while risk to bank depositors would theoretically increase (since CBs can’t be liquidated for depositors in a bank insolvency), a slight deposit insurance hike could offset that risk.

The benefits to borrowers would be measurable. Banks would have more international liquidity for their mortgages, which could directly result in lower interest costs and less pressure on banks to boost fees.

Granted, this idea may be a political hot potato at the moment. Daily headlines on housing overvaluation won’t make raising CB limits OSFI’s top priority. But regulators do a lot of taking, and sometimes they have to give a little too. A CB issuance policy that’s closer to international standards would be a net win for families slaving to pay their mortgage. To the extent the limit can be safely increased, policy-makers should help Canadians keep more money in their pockets.

  1. Now that we have moved to the covered bond 2.0 regime (a full, legal framework), I would expect that OSFI would consider a move to lift the issuance limit to say 5-6%. It’s an efficient funding source that I believe has been net beneficial for Canada. That said, I’d imagine that any increases would also result in additional CDIC fees.

  2. Rob – I couldn’t find this requirement in the CB guide – “mortgages are removed from the cover pool if they’re two months delinquent”. Please help.

      1. The following is a summary of Fitch’s comments on what Bloomberg (and this story) reported.

        Issuer “best practice” is to remove delinquent loans from the cover pool after 60 days. It’s not technically a requirement. However, once a loan is 3 months in arrears, it is deemed a “non-performing” loan and no longer counts towards the mandatory asset coverage test (ACT).

        If that happens en masse then an issuer will have to add more collateral. This ACT must be calculated every month by the issuer and is confirmed by an independent third party annually. Investors see these reports monthly, so issuers will periodically look at loans that are 60+ days delinquent and proactively remove them. Or the issuer may believe the loan will cure and leave it in.

        Rating agencies like Fitch performs reviews on issuers (banks + Desjardins) monthly. The last thing an issuer wants is a downgrade by a rating agency or loss of investor confidence. So it’s not surprising then, that in Fitch’s experience, once loans get to 60+ days in arrears the frequency of those loans in cover pools is significantly less than the industry average.

        Long story short, banks are managing loans in cover pools very well.

  3. Thanks for the clarification. I understand the best practice to meet the ACT and rating; however I don’t believe investors will rely on best practices to invest in CB.

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