Covered bonds have developed a following in Latin America, resulting in some notable deals, but the continent’s regulators seem divided on how best to manage them, with Brazil notably lagging. Potential issuers meanwhile seem uncertain as to whether legislation on the table will create attractive instruments. Alex Whiteman explores developments.

When the opening match of the World Cup kicks off in São Paulo on 12 June, all eyes will be on hosts Brazil, looking to add to their record haul of five World Cups. However, after going out in the quarter finals in South Africa 2010 and in 2013 recording their lowest ever Fifa ranking, expectations have been reined in.

The same is true of the hopes for covered bonds in Latin America, where a country that has several times been tipped to be the source of exciting supply has fallen behind its peers, with footballing rivals Chile and Uruguay having moved ahead of it in terms of deals and legislation, respectively.

According to Eduardo Rottmann, a specialist in housing finance based in São Paulo, by the end of 2013 a draft Brazilian covered bond law written by a working group coordinated by the Secretariat of Economic Policy at the country’s Ministry of Finance was almost complete. Rottman says the draft, which named the envisaged funding instrument letra imobiliária, was based on an existing instrument that would be reshaped.

“Despite the work that has been carried out on it, it seems that there is no major hurry to present it to Congress,” he says. “From what I can see, this seems to be down to a lack of champion.

“A few years ago Itáu was very interested, but it appears that it has changed its focus.”

Itáu Unibanco declined to be interviewed for this article.

Rottman’s view that there is no impetus or desire to pass the legislation any time soon is one shared by Gilberto Filho, director of real estate at Santander Brazil.

“We find ourselves getting close to legislation that regulates the market and tries to create the conditions for covered bonds,” says Filho. “It is an important initiative, but it needs a bit of improving for the markets.”

To explain this outlook, Filho says that the instrument, as proposed, is not yet attractive for either issuers or investors in Brazil given existing funding and investment opportunities, most notably a base interest rate, presently 11%, that is higher than what a covered bond would be able to offer investors, with mortgages originated at nominal terms of 9.5% and savings accounts, which provide funding for mortgages, paying close to 7%.

“If I originate a mortgage at 9.5%, how can I securitise this and create a covered bond that would pay less than market interest rates?” asks Filho. “Basically there is not a market for the paper.

“I do not see covered bonds taking off over the next three years because the interest rate would be below the base, risk-free interest rate currently on the market.”

Another barrier to progress, according to Filho, is that the financial institutions who could consider issuing believe that the framework proposed in the December 2013 draft could be simplified, and that potential costs could be reduced, in particular with respect to requirements to use external rating agencies.

“In Brazil you do not have an institution like Fannie Mae that defines a lot of standards on origination and documentation and also on ratings,” says Filho. “We would have to deal with many different rating agencies, each one with different processes and different standards, while the market settles to the new covered bond equilibrium.

“The framework proposed includes a lot of administration costs linked to issuance. We’d have to cater materials to different agencies.”

Access to an alternative source of funding, letra de crédito imobliário, also lessens the impetus behind the development of a covered bond framework in Brazil.

“It’s not a traditional covered bond, although it is a securitisation of mortgages, which lacks the rating needs and it’s very easy to use,” says Filho. “In my opinion, the transaction costs compared with covered bonds are minimal, which would prevent covered bonds, in the existing proposed form, from gaining traction.”

Chile surges ahead

In August 2013 Banco Santander Chile issued the first Chilean covered bond under an updated framework unveiled by the central bank and regulator in 2012.

Emiliano Muratore, manager of financial management at Banco Santander Chile, says that the Chilean issuer is eyeing the end of May to early June to return to the market with a second issue, which he says will most likely be for US$50m (Clp28.1bn, Eu36m) to US$100m and which the issuer began working on at the end of 2013.

Not content with just the one issue this year, the bank intends to quickly return with a third covered bond in July, one that Muratore hopes will involve participation from international investors. Thus far, international investment in Santander Chile’s covered bonds has not been forthcoming, with Muratore saying that several reasons, including a taxation issue, have been behind the international absence.

“Until 1 May when the new regime is coming into force, foreign investors suffered a 35% retention on every capital gain they generated trading domestic fixed income instruments,” says Muratore. “This was a big impediment to attracting foreign investment, especially for asset managers. In practice this took the foreign participation to less than 2% of the market — a very low figure compared to other countries in Latin America.”

However, he says that the bank has received some reverse enquiries on the matter, adding that the new regime has added to the level of international accounts expressing interest in investing.

“We plan to take advantage of the new regime to broaden the demand for mortgage bonds, and that is why we have been working with an international account to have them involved in the local placements we have in the pipeline,” says Muratore. “They are not going to be ready to participate in the deal we plan to do next month, but will be ready for future transactions.”

Chile’s largest mortgage originator’s first Bono Hipotecarios (as covered bonds are referred to in Chile) under the new framework was a US$67m 15 year, which came 16bp through the issuer’s senior unsecured curve via a Dutch auction. The price could have been driven tighter still, says Muratore, but it had already exceeded expectations of the covered bonds coming 10bp-15bp through the issuer’s senior unsecured curve.

Santander has tapped the inaugural issue twice, each time for UF1.5m (around $65m equivalent, UF being an inflation-adjusted currency unit in Chile). One of these taps came in August and was priced at 3.39% over UF, which Muratore says is equivalent to 114bp over the Chilean central bank yield and was 16bp tighter than Santander Chile senior unsecured spreads at the time. The second tap was launched in November and was priced at 3.35% over UF, equivalent to 128bp over central bank yields and 13bp inside the issuer’s senior unsecured curve.

For its next new issue Santander Chile is targeting pricing at a similar discount to its senior unsecured levels, namely of around 15bp, says Muratore. Aside from these taps, the bond has seen very little movement on the secondary market, with Muratore noting that as the covered bond is a new product for Chilean investors, the secondary market is non-existent.

As to deals from other issuers in Chile, Muratore says that he is aware of several banks that have made enquiries about covered bond issuance, but he is unaware how far into the process they are.

“No other banks have issued in Chile yet,” he says. “I think that they are taking a look at it and considering development of a programme.”

Muratore notes that the requirements in terms of IT infrastructure for the mortgage pool present hurdles that first need to be overcome.

“As the largest mortgage lender in Chile we have the responsibility to issue first, and I think other potential issuers have decided to hold back and see how it went and the perception of the market,” he adds.

Given the general consensus that Santander’s issue was well received, says Muratore, further supply would be no surprise.

“Medium to big banks in Chile must be working on the process to take advantage of the opportunities presented by covered bonds,” he says.

Unlike the jumbo deals found in the developed covered bond markets of Europe and North America, Muratore expects that the size of Chilean covered bonds will likely be consistent with what Santander has done to date. Muratore says this is because of the regulatory framework in Chile, which is set up to prioritise regularity of issuance over volume. Under the Chilean framework, mortgages that back the covered bonds must be originated after the Bono Hipotecarios notes are issued, and within 18 months.

Olivier Hassler, a housing finance advisor and consultant for The World Bank, believes that the new Chilean framework did not go far enough, leaving in place the many shortcomings present in the 1970s framework of Letras de Crédito Hipotecario (LCH), itself an update of long-existing legislation. These problems within the framework, Hassler says, are limiting the rating uplift in the same way that they contributed to a decline of covered bonds’ role in the Chilean mortgage market in the late 1970s.

“The new framework eliminated some rigidity factors (new loans and pass-through structure only), but has maintained the treatment of bonds in case of the issuer’s insolvency that is present in the LCH framework,” he adds. “Although separate from senior unsecured debt, this treatment provides a fairly weak investor protection mechanism, which means that rating uplift is minimal to non-existent.”

Working with what you’ve got

Though lacking specific covered bond legislation, Panama allows banks and financial institutions to issue covered bonds through a structured programme using a special purpose vehicle. Jorge Vallarino, vice president of financing at Global Bank, the first bank to issue covered bonds in Panama, believes that this set-up suits the country’s financing requirements without the need for a lengthy and protracted development of specific covered bond legislation.

In May 2012, Global Bank issued its first covered bond, a US$200m (Pab197m) mortgage-backed covered bond, with a May 2017 maturity and a 4.75% coupon. The deal was priced at a yield of 5%, equivalent to 438.5bp over US Treasuries, tightened from guidance of 5%-5.125%.

“The regulator was very aware, and both involved and supportive of structured covered bonds as a source of obtaining new funding at competitive levels,” says Vallarino. “Lack of specific regulation is not what is preventing banks from issuing, so there’s no need or push to spend time doing this.”

The bank returned to tap the bond in September for an additional $100m, prompted by the continuing growth of the bank and as such an additional need for funding. Vallarino says that tapping the bond was an attractive option for the issuer as there was investor interest and yields were attractive.

“It made sense to make it more liquid for investors, which was some of the feedback we got, with investors saying at $200m it was small, so we always had planned to come back and increase the size,” he says.

As for future issuance, the bank is somewhat limited by what it can offer and what investors would pay for, says Vallarino. Under the structured framework, its collateral pool was limited and as such so, too, was the programme, at $500m.

“We have no short term plans to return with a new issue,” says Vallarino. “We may look at doing something in a few years with the remaining $200m. Also, the outstanding matures in 2017, so when that gets close we may refinance and issue a new one to repay that one and grow the outstanding amount a little bit.”

Global Bank is happy with its covered bond progress, at least for the next few years, according to Vallarino, and a little bit of that has to do with the size. With the collateral it has available, he says, it would not make much sense to do a new $100m tranche, which would be very small, not very liquid and would probably require the bank to pay a premium due to the small size.

“When our bond came out we paid a premium as it was a new product, and investors were not sure about it, so it was trading a bit wider,” he says. “However, it has tightened significantly since.”

Vallarino is hopeful, however, that future issuance will attract investment from overseas, particularly looking towards Europe. “Our first issue came out when euro investors were concerned with what was going on with Europe and were not interested in getting paper in Latin America,” he adds.

The sum of its parts

Uruguay introduced covered bond legislation in 2010, in the form of Law 18.574, but there has yet to be any issuance under this framework, according to Carlos Mendive, a housing finance specialist in Uruguay and former president of the National Housing Agency.

In the intervening period, the country’s mortgage market has grown at a rate of 23%, or US$300m (Uyu6.7bn) (Eu216m), per year, says Mendive, who adds that he expects that rate to be exceeded this year, thanks in part to a new housing programme that provides the private sector with incentives for developing social housing for the middle and low-to-middle income sector of the population.

“This is a successful programme,” he says. “A lot of housing will be provided over the next two years as a result, with continued growth in the housing sector over the next five years.”

Alongside a growing mortgage market, Mendive says that the development of the covered bond market is being supported by the legislature having granted Notas de Crédito Hipotecarias the same tax treatment and exemptions as government bonds to increase their appeal to investors.

However, he says there is little reason for banks to avail themselves of the instrument.

“Uruguay’s financial and banking situation is very solid, with very good rates and stability within the system,” he says. “These, twinned with good liquidity ratios, leave the banks no incentive to issue.

“However, I believe that in the near future, covered bonds will provide an instrument to mitigate the risk that mortgage activity creates.”

Despite the growth of the mortgage market, and the implementation of a covered bond framework, an inaugural issue still evades Uruguay. Hassler says that while the option is there, covered bonds may not be a necessary tool for a mortgage market of Uruguay’s size.

“It is not enough to have a framework,” says Hassler. “Some countries even have multiple types of framework. You have to have market conditions, you have to have back-up services, and you have to have transparency on the real estate market with the ability to prove loan-to-values, for instance, with reliable appraisers and price indices.

“Institutional investors have to be available, macroeconomic stability is required for long term finance, and this has been a problem in Latin America for a long time. The macroeconomic context is a pre-requisite.”

Hassler highlights Argentina as an example where despite a developed mortgage market infrastructure, including relatively efficient foreclosure mechanisms, and diversified funding instruments, the macroeconomic problems it has faced over the years has led to instability and “killed long term finance”.

On the bench, but in form

Hassler cites Colombia and Mexico as two countries in Latin America with the potential for covered bond issuance, but he notes that the path towards covered bonds for these two nations is not without its own hurdles, some of which do not seem too far removed from the problems Brazilian covered bond legislation faces.

“Mexico certainly has a very strong case for covered bonds because it is stable and there is a relatively deep mortgage market,” says Hassler. “The main rationale [why covered bonds have not taken off] that I see is that the main lenders are commercial banks and they don’t have long term funding, and securitisation is fairly active, although expensive.”

Further, Hassler says that the country’s banking law prohibits the subordination of depositors’ priority claims to assets in the event of an issuer insolvency.

According to a housing finance specialist in the US, Mexico started reviewing ideas, but this was stopped by the Bank of Mexico because it believes the instrument could be detrimental to depositors.

Hassler adds that further legal developments in Mexico have been stalled because of a change in priorities following the election of a new Congress.

Because of the legal issues, the central bank and the regulator prepared another route, according to Hassler.

“It is a type of structured covered bond using a special purpose vehicle, with no specific law but with, however, some kind of supervision from the central bank,” Hassler says. “It would have circumvented the issue of the legislative process, but this route did not go through.”

Colombia also has definite market potential, according to Hassler, who noted as positive factors that it has “a very developed securitisation market accounting for 25% of the mortgage market”, strict regulatory requirements to ensure the quality of mortgage lending, and an instrument resembling a covered bond.

“There is a mortgage bond based on a law developed in 1999,” says the housing finance specialist. “It is not really a covered bond, but there are similarities, and the government has been persuaded to work on an initiative to develop this further and come up with a covered bond framework.”

Hassler adds that the existing instrument has not really taken off as its pass-through structure makes it very close to securitisation, and that it has to be indexed to inflation by law.

“Since now most of the mortgage loans are no longer indexed because the macroeconomic environment is stable, it’s a big constraint,” says Hassler. “Eventually, with a new type of covered bond legislation featuring less constraints, it would be easy to develop a covered bond market, and quickly.”

Hassler is of the opinion that, as with Mexico, the Colombian government needs to remove what he believes are key obstacles, including a compulsory pass-through structure, adding that pass-through is “not only useless anyway because securitisation does that already, but also hinders overcollateralisation (in the absence of Danish-style capital centres)”.

“Foreign investors would be drawn to Mexico and Colombia because the macroeconomy is good,” Hassler adds. “You also have the close geographic links to the US so there are lots of investor candidates from the US who are familiar with these markets.”