Covered bond issuance from 2015 onwards could be dampened by the introduction of TLAC requirements, analysts have warned, even if preferential treatment under other regulation will support supply and give covered bonds an important advantage over other asset classes.

Many analysts see Financial Stability Board (FSB) total loss absorbing capacity (TLAC) proposals as a potential drag on covered bond issuance, as banks meet funding needs through the issuance of other instruments. These proposals, released last month, rule that globally systemically important banks (G-SIBs) must hold TLAC of 16%-20% of their risk-weighted assets, or a minimum of twice the relevant Tier 1 leverage ratio requirement.

Debt issued in the forms of covered bonds will not count towards TLAC, while senior debt issued at operating company level also will only be eligible to a limited extent (2.5% of RWA). With holding company senior bond issuance restricted by legal hurdles in Europe, according to analysts, continental European banks could come under pressure to issue more debt in eligible asset classes such as Additional Tier 1 and Tier 2.

If the ratio of equity to total assets is taken as a proxy for the leverage ratio and the floor of 16% plus capital buffer for proposed rules’ minimum Pillar 1 capital requirements, Eurozone banks must raise TLAC of a further Eu70bn over the next few years to satisfy the criteria, analysts at LBBW calculated.

Although the proposals will not be finalised until the market provides feedback next year or implemented until 1 January 2019, some analysts warn covered bond issuance will be affected from 2015 onwards, as issuers anticipate the changes and take advantage of resulting favourable conditions for senior unsecured and subordinated debt.

“The Financial Stability Board’s proposals outlining total loss absorbing capacity for financial institutions would likely make issuers prioritise unsecured, over secured funding,” said analysts at Société Générale. “This will bode poorly for those investors hoping to see a reversal of negative net supply in 2015.”

Analysts at Citi also said the market should expect an eventual shift from covered bonds to TLAC-conformant asset classes, such as AT1, T2 and HoldCo senior debt instruments, noting that 16 G-SIBS are active covered bond issuers. However, they said that TLAC’s impact should not be so pronounced in the short term.

“The new TLAC rules might already be felt in 2015,” said the analysts. “TLAC will probably remain a drag for covered bond supply during the next four years, but its impact should be limited in 2015.”

Analysts at ABN AMRO added that banks will likely use junior instruments, such as equity, AT1 or AT2, to build further buffers to reduce the possible impact of bail-in on senior unsecured debt, meaning they could issue covered bonds simultaneously.

“Furthermore, the TLAC proposals will mean that the issuance of senior unsecured paper will be done at the holding company level,” the analysts said. “Banks may then prefer to issue this kind of debt to issuing senior unsecured paper. In this case, banks could issue more covered bonds alongside the junior paper in order to reduce overall bank funding costs.”

DZ Bank analysts, meanwhile, regard TLAC as credit positive for holders of covered bonds.

“We expect the banks concerned to gradually replace their unsecured bonds with TLAC and/or MREL-conformant instruments over the next few years on the scale needed and as they mature,” they added. “We believe that progressive substitution in this way would enable banks to build up the required buffers in good time over the anticipated transitional periods.

“On this basis, we do not foresee any significant increase in the issuance of new unsecured bonds at the expense of covered bonds during 2015.”

Elsewhere on the regulatory front, there is a consensus among analysts that supportive treatment of covered bonds – such as an exemption from bail-in under the BRRD and preferential treatment in terms of LCR requirements – will contribute to a positive 2015 for covered bonds, even while the market is likely to experience a third year of negative net supply.

“The attractiveness of covered bonds compared with other asset classes is additionally confirmed by the preferential regulation of covered bonds under the LCR and their ex-emption from participating in the resolution of insolvent banks (bail-in),” said Alfred Anner, senior covered bond analyst at BayernLB. “That should make the asset class appear advantageous to many investors in respect to future over-all allocation.”

The Bank Recovery & Resolution Directive (BRRD), which will come into force next year, rules that secured liabilities such as covered bonds will not be subject to losses in the event of an issuer failure, protecting the preferential claim of covered bond-holders.

Analysts at Crédit Agricole added that the bail-in exemption demonstrates that there is political will to protect the product.

“Covered bonds are seen as the private sector funding tool of last resort and are being protected as such,” they said.

The leading rating agencies have already updated their methodologies to reflect covered bonds’ advantageous position, resulting in upgrades for many programmes that will, in most cases, make up for potential downgrades because of a likely weakening of government support for failing banks in 2015.

Meanwhile, as covered bonds will be the only private assets ranked as Level 1 under the Liquidity Coverage Ratio (LCR), analysts expect their attractiveness to increase further.

“The classification of covered bonds as Level 1 and Level 2 is very positive,” said analysts at HSBC. “We expect that many European bank treasuries will use covered bonds in addition to sovereign, agency and supranational debt and will optimise their liquid asset portfolio under both liquidity and risk-return considerations.”

However, they added the spread impact on covered bonds should be limited as spreads are already compressed due to CBPP3, negative net supply and TLTROs.

According to Société Générale’s calculations, only a few covered bonds from core EU markets would not qualify as Level 1 assets, namely Commerzbank SME covered bonds, Achmea Hypotek covered bonds, and the French structured covered bonds of Banques Populaire Covered Bonds and Groupe Caisse d’Epargne Covered Bonds.

Another impact of LCR will be increased market sensitivity to rating changes, according to Heiko Langer, senior covered bond analyst at BNP Paribas. As LCR eligibility will be linked to a minimum rating of AA- (for Level 1) and A- (for Level 2A), ratings will gain in importance, he said, allowing issuers rated A- or AA- easier access to the primary market.

Photo: Mark Carney, FSB chair and Bank of England governor, during a visit to Goodison Park to support Everton in the Community in his role as ambassador; Source: Everton FC, Bank of England