After retrenching their wholesale funding in recent years, UK financial institutions are beginning to re-establish a presence in the primary markets. But with the senior unsecured and bank capital segments in fine fiddle, a pick-up of UK covered bond supply is having to wait its turn. Susanna Rust reports.

In the past two years euro covered bond investors have had just one chance to get their hands on fresh UK benchmark supply – a Eu1bn seven year Regulated Covered Bond (RCB) launched by Santander UK last November. Sterling issuance has also been thin on the ground, with a £1bn (Eu1.20bn) three year FRN from Lloyds Bank in January this year having been the first domestic UK covered bond since June 2012.

Compare that with the Eu21.35bn of UK euro benchmark covered bond supply that hit the market in 2011, or £9.75bn of sterling issuance in 2012, and it is clear that UK benchmark covered bond supply has fallen drastically.

“There has been very little covered bond supply from the UK in the past couple of years on the back of deleveraging, the introduction of the FLS, increased retail deposits, and at times also because of cost, in that spreads haven’t reflected the value of the collateral sufficiently,” says Hugo Moore, co-head of covered bonds at HSBC in London.

Introduced in July 2012 by the UK government and the Bank of England to boost lending to the real economy, the Funding for Lending Scheme (FLS) has frequently been cited as contributing to keeping UK issuers away from the public bond markets given comparatively cheaper funding available under the scheme. Originally due to end in January this year, the scheme has been extended until January 2015, but is now exclusively geared towards incentivising lending to businesses rather than private households.

But John Millward, director, structured finance at HSBC, says that the picture is more nuanced than that, varying across different financial institutions depending in part on whether they are deleveraging or in growth mode.

“I don’t think that it tells the whole story to say that the FLS has replaced other forms of wholesale funding,” he says. “What it has done is provide another outlet for funding.”

Arguably the most profound impact of the FLS is an indirect one, according to Millward.

“The FLS provided institutions with certainty about their funding costs, and that has precipitated a significant reduction in the cost of retail funding,” he says. “That allied with institutions building up liquidity buffers and/or the effects of deleveraging has led to lower overall wholesale funding requirements.”

Indeed, in a November financial stability report the Bank of England itself noted that “UK banks continued to reduce their reliance on wholesale debt funding”, partly reflecting robust deposit growth, but that market-based funding costs had fallen substantially since the FLS was introduced. (See chart.)

The FLS, says Millward, is “part of the puzzle but not the whole puzzle”.

Indeed, Tom Ranger, head of funding at Santander UK, notes that the issuer only drew some £100m under the scheme, and attributes a dip in wholesale funding volumes to lower wholesale funding requirements.

“UK banks are very liquid and in a very strong place after having gone through a big adjustment a few years ago, so 2013 was more of a normalisation,” he says. “I expect new issuance volumes in 2014 will go back to a cross between 2013 and 2012 volumes.”

Moore at HSBC says that he expects UK covered bond issuance to pick up this year in euros and sterling.

“As the market tone has improved and spreads have tightened we have seen three transactions from UK issuers in euros and sterling,” he says, “and I would expect more.”

Not the only game in town

And yet covered bond funding is not top of the priority list for issuers, it seems.

Abbey National Treasury Services’ Eu1bn seven year RCB from November, for example, marked the tail-end of the 2013 funding plan for Santander UK, the RCB issuer’s parent.

Speaking to The Covered Bond Report after the deal, Ranger said that a euro covered bond had always been part of Santander UK’s funding strategy for 2013, but that the bank first concentrated on the senior unsecured market as a segment of the wholesale funding markets from which it had been absent for a longer time.

“We had a very clear funding strategy […] to keep connected with those markets where we’ve been active, which historically has been covered bonds and ABS, and to re-connect with those markets where we haven’t been so active but wanted to be,” he said.

Santander UK raised funding in the senior unsecured market twice in 2013, in euros and US dollars, and also sold an ABS. Completion of a $1.5bn 5% 10 year Tier 2 subordinated debt offering on 31 October paved the way for the issuer to turn its attention to its plans for a fourth quarter euro covered bond, according to Ranger.

“The Tier 2 deal was very important for us as it was the first time that Santander UK issued subordinated debt since 2005,” he says. “Once that was done we looked at covered bonds and have been assessing different maturities.”

Leads Credit Suisse, HSBC, Santander, UBS and UniCredit priced the issue at 21bp over mid-swaps, the tight end of guidance of the 23bp over area, on the back of Eu1.6bn of orders.

“We’re very pleased with the transaction,” said Ranger. “It was a great return for us in the euro covered bond market and hopefully a great return for UK issuers, too.”

For now, however, UK issuers are more focussed on the senior unsecured market and on building up loss-absorbing capital to meet new regulations, notes Jez Walsh, head of covered bond syndicate at Royal Bank of Scotland.

“Covered bond spreads have been compressed for some time now and are so tight you might wonder why there has not been more issuance,” he says, “but senior unsecured spreads have also tightened significantly, and when you factor in the all-in cost of funding on covereds, there is a broader desire at the moment to do senior funding.”

Indeed, at the time of writing Nationwide Building Society had just priced a well-received inaugural Additional Tier 1 (AT1) transaction, the first such issue in sterling, and Lloyds Bank had launched an Enhanced Capital Notes into AT1 exchange offer.

In the flow funding market, meanwhile, Yorkshire Building Society had finished a roadshow for a potential euro senior unsecured transaction, with Chris Parrish, group treasurer at the issuer, citing improved conditions in the senior unsecured market as part of the reason for the issuer’s move.

“We are growing our net lending quite strongly so we want to re-establish ourselves in all wholesale funding markets, with a balanced funding profile across covered bonds, senior unsecured and RMBS,” he says. “We’ve seen a recovery of conditions in the senior unsecured market, with the relative pricing of senior having come in, and good investor demand, so going down that route is more a question of timing than anything.”

Yorkshire’s last senior unsecured transactions were some 10 years ago, a euro deal in 2004 and a US dollar issue in 2005, according to Parrish. It initially thereafter concentrated on covered bonds before the financial crisis ushered in a period of government-guaranteed senior unsecured issuance, and after a euro benchmark covered bond in 2010 the building society has in the past three years issued sterling RMBS, alongside some domestic covered bond supply in 2011 and 2012. Its last benchmark covered bond was a £500m four year FRN issued in March 2012, with its last euro deal a Eu600m five year in September 2010.

Yorkshire reported strong 2013 financial results at the end of February, including a 222% increase in net lending and a record market share of 17.4%. As at 31 January it had drawn down £2.35bn from the FLS.

Clydesdale Bank, meanwhile, is set to re-open the UK master trust RMBS market, having announced a mandate for a euro and sterling denominated trade off its Lanark programme. Clydesdale last tapped the benchmark covered bond market in July 2012, with a £400m three year FRN. That was the last UK sterling covered bond before Lloyds re-opened the market in January with its £1bn three year FRN, with Abbey following suit a week later.

Mike McCormick, co-head of covered bonds at HSBC, notes that with RMBS, UK financial institutions have access to a more collateral-efficient funding instrument than covered bonds, in that overcollateralisation (OC) tends to be two to three times higher for a soft bullet covered bond than RMBS.

“That is a factor that UK issuers will weigh when considering their funding options,” he says, “as is the cost of cross-currency swaps in case of euro covered bond issuance, especially for lower rated issuers that need to use an external counterparty.”

One of the most important market developments in the recent history of covered bonds occurred in 2013 while UK issuers were absent from the market, namely a groundbreaking sale of conditional pass-through (CPTs) covered bonds by Dutch issuer NIBC Bank in October.

No other issuer has yet to follow in NIBC’s footsteps despite the many benefits that bankers attribute to the CPT structure, such as rating uplift and reduced overcollateralisation requirements.

Lower rated UK financial institutions have been identified as potential candidates, but McCormick does not believe that partial pass-through covered bonds make that much sense for most UK issuers.

“Anyone with an existing soft bullet covered bond would have to set up a new programme to employ pass-through features and a UK issuer accessing the euro market with a conditional pass-through covered bond would face higher costs for a cross-currency swap than they would for a soft bullet given the long extension,” he says. “The sterling RMBS market offers UK financial institutions an attractive alternative to soft bullet covered bonds in terms of collateral efficiency and hedging costs, so that is another consideration.

“Pass-through mechanisms are a strong structural feature but I would be cautious about the likely volume of issuance of pass-through covered bonds even though investor sentiment seems favourable towards it.”

Adapting to new regs

Any UK issuer coming to market now will be doing so under a revised framework, following changes to the Regulated Covered Bond Regulations that came into effect in January 2013. A few months later, a well-flagged split of the Financial Services Authority took place, resulting in two new regulatory bodies, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

Supervision of covered bonds issued under the UK’s Regulated Covered Bond framework falls under the remit of the FCA, which Anna Simons, capital markets team at FCA, says marks continuity with the previous arrangement.

“The markets division has always been responsible for covered bond supervision to avoid a conflict of interest between supervising the RCB regime and supervising the issuers,” she says.

“When the FSA split, the markets division remained in the FCA, which means that covered bond supervision has not moved. Prudential supervision of the issuers is the responsibility of the PRA.”

Issuers have, however, faced some changes as a result of amendments made in late 2011, effective January last year, to the UK’s covered bond legal framework. New reporting requirements include: having to notify the FCA of any significant substitutions made to the cover pool resulting in a change to the level of overcollateralisation of 5% or more; and monthly information on the asset and liability profile and on the cover pool. Public reporting requirements have also changed, with issuers having to designate asset pools either as composed of a single class of eligible assets or a mixture of eligible asset classes, and also provide loan-level data information.

The requirement for disclosure of loan-level data is rare among covered bond frameworks, and broadly mirrors Bank of England repo eligibility criteria for covered bonds, with UK market participants’ experience with securitisation seen as facilitating the application of the practice to covered bonds.

The ICMA Covered Bond Investor Council has come out against requiring loan-level data in covered bonds, having in the past expressed concern that this would “contaminate” the asset class, but Simons at the FCA says that the information is designed to provide transparency for investors.

She notes that the requirement for loan level data only applies following issuance of RCBs since January last year, and that the lack of supply since then would make it premature to formally seek feedback on this new aspect of the regulations.

“There have not been major problems so far, although it is early days,” she says. “Issuers have been complying and one issuer is voluntarily doing so. The whole point of loan-level data is to make it available to investors.”

Another outcome of the policy review and consultation around the amendments to the RCB regime has been the creation of the UK Covered Bond Forum, an industry forum chaired by the FCA.

“We engaged widely with issuers and investors as part of the policy review in 2011 and 2012 and generally felt that the level of understanding of the RCB framework appeared good,” says Simons. “There were some good suggestions, many of which were implemented, and a Regulated Covered Bond forum came up as an idea to discuss concerns and key issues.

“It’s been well attended, by all RCB issuers, and trade bodies and investors are invited, with HM Treasury and Bank of England also represented.”

Asked about the challenges facing the UK covered bond market, Chris Fielding, executive director at the UK Regulated Covered Bond Council (RCBC), says that they are ones that the UK shares with the rest of the European market.

“The challenges are for covered bonds overall, and come from things like CRD IV, Solvency and Solvency II, ring-fencing, and bail-in,” he says. “My hope is that regulators and policymakers are focussing on the cumulative impact of these regulations and that they are sympathetic to covered bonds, as long as the definition of the asset class is not restricted to on-balance sheet structures.”

Under the UK RCB regime, asset segregation is achieved by cover assets being separated from an issuer’s balance sheet through a sale to a special purpose vehicle.

However, Fielding believes that key features of UK Regulated Covered Bonds are not yet fully appreciated by market participants.

“Occasionally I have heard worrying misconceptions about Regulated Covered Bonds, but these come from a small minority,” says Fielding. “But still, in my opinion the strength of legislation and the RCB Regulations, combined with the rigour of ongoing FCA supervision, is not yet adequately rewarded.”

After retrenching their wholesale funding in recent years, UK financial institutions are beginning to re-establish a presence in the primary markets. But with the senior unsecured and bank capital segments in fine fiddle, a pick-up of UK covered bond supply is having to wait its turn. Susanna Rust reports.

In the past two years euro covered bond investors have had just one chance to get their hands on fresh UK benchmark supply – a Eu1bn seven year Regulated Covered Bond (RCB) launched by Santander UK last November. Sterling issuance has also been thin on the ground, with a £1bn (Eu1.20bn) three year FRN from Lloyds Bank in January this year having been the first domestic UK covered bond since June 2012.

Compare that with the Eu21.35bn of UK euro benchmark covered bond supply that hit the market in 2011, or £9.75bn of sterling issuance in 2012, and it is clear that UK benchmark covered bond supply has fallen drastically.

“There has been very little covered bond supply from the UK in the past couple of years on the back of deleveraging, the introduction of the FLS, increased retail deposits, and at times also because of cost, in that spreads haven’t reflected the value of the collateral sufficiently,” says Hugo Moore, co-head of covered bonds at HSBC in London.

Introduced in July 2012 by the UK government and the Bank of England to boost lending to the real economy, the Funding for Lending Scheme (FLS) has frequently been cited as contributing to keeping UK issuers away from the public bond markets given comparatively cheaper funding available under the scheme. Originally due to end in January this year, the scheme has been extended until January 2015, but is now exclusively geared towards incentivising lending to businesses rather than private households.

But John Millward, director, structured finance at HSBC, says that the picture is more nuanced than that, varying across different financial institutions depending in part on whether they are deleveraging or in growth mode.

“I don’t think that it tells the whole story to say that the FLS has replaced other forms of wholesale funding,” he says. “What it has done is provide another outlet for funding.”

Arguably the most profound impact of the FLS is an indirect one, according to Millward.

“The FLS provided institutions with certainty about their funding costs, and that has precipitated a significant reduction in the cost of retail funding,” he says. “That allied with institutions building up liquidity buffers and/or the effects of deleveraging has led to lower overall wholesale funding requirements.”

Indeed, in a November financial stability report the Bank of England itself noted that “UK banks continued to reduce their reliance on wholesale debt funding”, partly reflecting robust deposit growth, but that market-based funding costs had fallen substantially since the FLS was introduced. (See chart.)

The FLS, says Millward, is “part of the puzzle but not the whole puzzle”.

Indeed, Tom Ranger, head of funding at Santander UK, notes that the issuer only drew some £100m under the scheme, and attributes a dip in wholesale funding volumes to lower wholesale funding requirements.

“UK banks are very liquid and in a very strong place after having gone through a big adjustment a few years ago, so 2013 was more of a normalisation,” he says. “I expect new issuance volumes in 2014 will go back to a cross between 2013 and 2012 volumes.”

Moore at HSBC says that he expects UK covered bond issuance to pick up this year in euros and sterling.

“As the market tone has improved and spreads have tightened we have seen three transactions from UK issuers in euros and sterling,” he says, “and I would expect more.”

Not the only game in town

And yet covered bond funding is not top of the priority list for issuers, it seems.

Abbey National Treasury Services’ Eu1bn seven year RCB from November, for example, marked the tail-end of the 2013 funding plan for Santander UK, the RCB issuer’s parent.

Speaking to The Covered Bond Report after the deal, Ranger said that a euro covered bond had always been part of Santander UK’s funding strategy for 2013, but that the bank first concentrated on the senior unsecured market as a segment of the wholesale funding markets from which it had been absent for a longer time.

“We had a very clear funding strategy […] to keep connected with those markets where we’ve been active, which historically has been covered bonds and ABS, and to re-connect with those markets where we haven’t been so active but wanted to be,” he said.

Santander UK raised funding in the senior unsecured market twice in 2013, in euros and US dollars, and also sold an ABS. Completion of a $1.5bn 5% 10 year Tier 2 subordinated debt offering on 31 October paved the way for the issuer to turn its attention to its plans for a fourth quarter euro covered bond, according to Ranger.

“The Tier 2 deal was very important for us as it was the first time that Santander UK issued subordinated debt since 2005,” he says. “Once that was done we looked at covered bonds and have been assessing different maturities.”

Leads Credit Suisse, HSBC, Santander, UBS and UniCredit priced the issue at 21bp over mid-swaps, the tight end of guidance of the 23bp over area, on the back of Eu1.6bn of orders.

“We’re very pleased with the transaction,” said Ranger. “It was a great return for us in the euro covered bond market and hopefully a great return for UK issuers, too.”

For now, however, UK issuers are more focussed on the senior unsecured market and on building up loss-absorbing capital to meet new regulations, notes Jez Walsh, head of covered bond syndicate at Royal Bank of Scotland.

“Covered bond spreads have been compressed for some time now and are so tight you might wonder why there has not been more issuance,” he says, “but senior unsecured spreads have also tightened significantly, and when you factor in the all-in cost of funding on covereds, there is a broader desire at the moment to do senior funding.”

Indeed, at the time of writing Nationwide Building Society had just priced a well-received inaugural Additional Tier 1 (AT1) transaction, the first such issue in sterling, and Lloyds Bank had launched an Enhanced Capital Notes into AT1 exchange offer.

In the flow funding market, meanwhile, Yorkshire Building Society had finished a roadshow for a potential euro senior unsecured transaction, with Chris Parrish, group treasurer at the issuer, citing improved conditions in the senior unsecured market as part of the reason for the issuer’s move.

“We are growing our net lending quite strongly so we want to re-establish ourselves in all wholesale funding markets, with a balanced funding profile across covered bonds, senior unsecured and RMBS,” he says. “We’ve seen a recovery of conditions in the senior unsecured market, with the relative pricing of senior having come in, and good investor demand, so going down that route is more a question of timing than anything.”

Yorkshire’s last senior unsecured transactions were some 10 years ago, a euro deal in 2004 and a US dollar issue in 2005, according to Parrish. It initially thereafter concentrated on covered bonds before the financial crisis ushered in a period of government-guaranteed senior unsecured issuance, and after a euro benchmark covered bond in 2010 the building society has in the past three years issued sterling RMBS, alongside some domestic covered bond supply in 2011 and 2012. Its last benchmark covered bond was a £500m four year FRN issued in March 2012, with its last euro deal a Eu600m five year in September 2010.

Yorkshire reported strong 2013 financial results at the end of February, including a 222% increase in net lending and a record market share of 17.4%. As at 31 January it had drawn down £2.35bn from the FLS.

Clydesdale Bank, meanwhile, is set to re-open the UK master trust RMBS market, having announced a mandate for a euro and sterling denominated trade off its Lanark programme. Clydesdale last tapped the benchmark covered bond market in July 2012, with a £400m three year FRN. That was the last UK sterling covered bond before Lloyds re-opened the market in January with its £1bn three year FRN, with Abbey following suit a week later.

Mike McCormick, co-head of covered bonds at HSBC, notes that with RMBS, UK financial institutions have access to a more collateral-efficient funding instrument than covered bonds, in that overcollateralisation (OC) tends to be two to three times higher for a soft bullet covered bond than RMBS.

“That is a factor that UK issuers will weigh when considering their funding options,” he says, “as is the cost of cross-currency swaps in case of euro covered bond issuance, especially for lower rated issuers that need to use an external counterparty.”

One of the most important market developments in the recent history of covered bonds occurred in 2013 while UK issuers were absent from the market, namely a groundbreaking sale of conditional pass-through (CPTs) covered bonds by Dutch issuer NIBC Bank in October.

No other issuer has yet to follow in NIBC’s footsteps despite the many benefits that bankers attribute to the CPT structure, such as rating uplift and reduced overcollateralisation requirements.

Lower rated UK financial institutions have been identified as potential candidates, but McCormick does not believe that partial pass-through covered bonds make that much sense for most UK issuers.

“Anyone with an existing soft bullet covered bond would have to set up a new programme to employ pass-through features and a UK issuer accessing the euro market with a conditional pass-through covered bond would face higher costs for a cross-currency swap than they would for a soft bullet given the long extension,” he says. “The sterling RMBS market offers UK financial institutions an attractive alternative to soft bullet covered bonds in terms of collateral efficiency and hedging costs, so that is another consideration.

“Pass-through mechanisms are a strong structural feature but I would be cautious about the likely volume of issuance of pass-through covered bonds even though investor sentiment seems favourable towards it.”

Adapting to new regs

Any UK issuer coming to market now will be doing so under a revised framework, following changes to the Regulated Covered Bond Regulations that came into effect in January 2013. A few months later, a well-flagged split of the Financial Services Authority took place, resulting in two new regulatory bodies, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

Supervision of covered bonds issued under the UK’s Regulated Covered Bond framework falls under the remit of the FCA, which Anna Simons, capital markets team at FCA, says marks continuity with the previous arrangement.

“The markets division has always been responsible for covered bond supervision to avoid a conflict of interest between supervising the RCB regime and supervising the issuers,” she says.

“When the FSA split, the markets division remained in the FCA, which means that covered bond supervision has not moved. Prudential supervision of the issuers is the responsibility of the PRA.”

Issuers have, however, faced some changes as a result of amendments made in late 2011, effective January last year, to the UK’s covered bond legal framework. New reporting requirements include: having to notify the FCA of any significant substitutions made to the cover pool resulting in a change to the level of overcollateralisation of 5% or more; and monthly information on the asset and liability profile and on the cover pool. Public reporting requirements have also changed, with issuers having to designate asset pools either as composed of a single class of eligible assets or a mixture of eligible asset classes, and also provide loan-level data information.

The requirement for disclosure of loan-level data is rare among covered bond frameworks, and broadly mirrors Bank of England repo eligibility criteria for covered bonds, with UK market participants’ experience with securitisation seen as facilitating the application of the practice to covered bonds.

The ICMA Covered Bond Investor Council has come out against requiring loan-level data in covered bonds, having in the past expressed concern that this would “contaminate” the asset class, but Simons at the FCA says that the information is designed to provide transparency for investors.

She notes that the requirement for loan level data only applies following issuance of RCBs since January last year, and that the lack of supply since then would make it premature to formally seek feedback on this new aspect of the regulations.

“There have not been major problems so far, although it is early days,” she says. “Issuers have been complying and one issuer is voluntarily doing so. The whole point of loan-level data is to make it available to investors.”

Another outcome of the policy review and consultation around the amendments to the RCB regime has been the creation of the UK Covered Bond Forum, an industry forum chaired by the FCA.

“We engaged widely with issuers and investors as part of the policy review in 2011 and 2012 and generally felt that the level of understanding of the RCB framework appeared good,” says Simons. “There were some good suggestions, many of which were implemented, and a Regulated Covered Bond forum came up as an idea to discuss concerns and key issues.

“It’s been well attended, by all RCB issuers, and trade bodies and investors are invited, with HM Treasury and Bank of England also represented.”

Asked about the challenges facing the UK covered bond market, Chris Fielding, executive director at the UK Regulated Covered Bond Council (RCBC), says that they are ones that the UK shares with the rest of the European market.

“The challenges are for covered bonds overall, and come from things like CRD IV, Solvency and Solvency II, ring-fencing, and bail-in,” he says. “My hope is that regulators and policymakers are focussing on the cumulative impact of these regulations and that they are sympathetic to covered bonds, as long as the definition of the asset class is not restricted to on-balance sheet structures.”

Under the UK RCB regime, asset segregation is achieved by cover assets being separated from an issuer’s balance sheet through a sale to a special purpose vehicle.

However, Fielding believes that key features of UK Regulated Covered Bonds are not yet fully appreciated by market participants.

“Occasionally I have heard worrying misconceptions about Regulated Covered Bonds, but these come from a small minority,” says Fielding. “But still, in my opinion the strength of legislation and the RCB Regulations, combined with the rigour of ongoing FCA supervision, is not yet adequately rewarded.”