A Chinese covered bond market would have the potential to become the largest in Asia, Fitch said yesterday (Thursday), if it were based on a standardised framework or covered bond law – conditions not satisfied by a recent green issue for Bank of China.

BOC’s $500m (RMB3.38bn, Eu451m) three year issue on 3 November was the first deal out of China to be marketed as a covered bond. The dual recourse transaction was backed by a portfolio of 11 green bonds from six domestic issuers. However, many market participants argued the deal did not qualify for the “covered bond” tag given differences from conventional issuance, including the lack of a specific framework and public supervision.

While acknowledging that China’s covered bond market is only in the very early stages of development, in a comment published yesterday (Thursday) Fitch stated its belief that the nascent market could become the largest in Asia.

The rating agency said covered bonds would expand the funding options available to China’s banks. It noted that Chinese commercial banks have access to a deep and diverse pool of assets, some of which are now being securitised to generate funding, and that securities backed by mortgages and automotive loans have already been sold to international investors.

Fitch said, however, that the Chinese market will only realise this potential if it is able to meet investors’ expectations, which include the use of a standardised legal regime or covered bond regulation that has the backing of regulators and issuers. No such framework yet exists in China, meaning that investors would lack many of the protections afforded them by covered bond frameworks in established markets.

“Some covered bond markets that did not initially have specific legislation in place, such as New Zealand, started issuing covered bonds based on contractual arrangements,” said the rating agency. “However, no market has developed successfully without having domestic banking authorities involved in setting standards and monitoring programmes.

“We believe registration and oversight by regulators tend to make investors more comfortable with a debt instrument.”

Fitch highlighted that the priority ranking of covered bondholders in an insolvency scenario is supported in all countries that have dedicated legislation, but said that in China there is a risk that assets held by financial institutions could be subject to a moratorium, and bondholders could be subordinated to depositors and other creditors.

Measures to achieve segregation of cover assets will also be important, in Fitch’s view, whether in the form of an exemption to bankruptcy laws or through a transfer of the assets to a special purpose vehicle (SPV). Fitch noted that securitisations it rates utilise this SPV model, and said this could be an option for Chinese covered bonds while no such exemptions to bankruptcy laws are yet in place.

If the Chinese market is to follow international best practice, cross-currency swaps must also be used for foreign currency issuance backed by renminbi-denominated mortgages, the rating agency said.

“Fitch would not rate covered bonds above their issuer’s long term rating if the entire programme was unhedged, given the potential for extreme foreign exchange volatility,” it added.

Fitch also noted a preference in most established covered bond jurisdictions for issuance backed by the “relatively homogeneous assets” of mortgage or public sector loans, and cited the importance of issuance being backed by granular cover pools.