The first Japanese covered bond could be launched soon, with Sumitomo Mitsui Banking Corporation (SMBC) beginning a roadshow next week for a five year euro-dominated benchmark, which will be based on a contractual structure given Japan’s lack of a legislative framework.

A variety of Japanese covered bond initiatives have come and gone for more than 10 years, including a government-sponsored working group early this decade. Shinsei Bank came close to issuing a contractual covered bond in 2008 but pulled out of two attempts, while SMBC itself was said to have explored covered bond options as far back as that same year.

It was announced today (Thursday) that the megabank will from next Wednesday roadshow a EUR20bn (¥2.56tr) covered bond programme, of which Goldman Sachs and SMBC Nikko are lead arrangers. Subject to market conditions, a five year euro-denominated Reg S benchmark transaction will follow via Goldman Sachs, SMBC Nikko, Barclays, BNP Paribas, Crédit Agricole and UBS.

“Historically, Japanese banks have not been active in the secured market due to [the] absence of dedicated covered bond legislation,” says an SMBC roadshow presentation. “Our contractual framework will satisfy key covered bond requirements for the investors and will grant SMBC access to broader capital markets to further diversify [its] investor base.”

The issuer of the covered bond will be SMBC and the collateral backing the dual recourse instrument will be self-originated triple-A rated Japanese residential mortgage-backed securities (RMBS).

Asset segregation is achieved by collateral being held in a trust account by SMBC according to Japan’s Trust Act, which is therefore not available to general creditors of SMBC. The collateral is included in the cover pool by virtue of a total return swap (TRS) between SMBC acting as trustee and SMBC acting in its proprietary capacity.

This method of asset segregation is understood to build on a quasi-covered bond structure, SumitG, involving Goldman Sachs and Japan’s Sumitomo Mitsui in October 2016.

“The challenge of segregating assets for the benefit of covered bond-holders was one of the main reasons why we haven’t seen covered bonds from Japan before,” a banker told The CBR, “because the concept of the true sale as we know it does not exist legally in Japan. The best way of ultimately making sure that covered bond investors have access to the cover pool in the case of event of default of issuer or guarantor needed to be figured out, and the SumitG trade was the prelude to this.”

The covered bonds are expected to be rated Aaa by Moody’s. SMBC itself is rated A1/A by Moody’s and S&P.

Credit enhancement includes minimum overcollateralisation (OC) of 25%, which is higher than in most traditional covered bond jurisdictions with legislation, while the triple-A rated RMBS have their own layer of credit enhancement. The weighted average loan to value (LTV) ratio is 90.1%, with high LTV mortgages being typical in Japan, but LTVs are capped at 80% for the purposes of the asset coverage test (ACT) calculation.

“You have quite a lot of credit enhancement here,” said the banker. “Obviously they are trying to go to an investor universe that is not familiar with Japan’s mortgage market – which is actually one of the strongest in the world, with an exceptionally low delinquency rate, for example – and also they understand that a lot of investors are used to legislative frameworks, and they want to mitigate that with this additional protection.”

A debut covered bond from SMBC would break what has at times appeared to be a regulatory impasse in Japan.

“Similar to what we have seen in the UK and Canada, the banks – with the blessing of the authorities – are now going to be issuing contractual covered bonds and once you see the volumes going up, one would imagine that the regulator would put legislation around it,” suggested a market participant.

“I believe SMBC will be followed by the other megabanks,” he added, “and this has the potential to become one of the biggest covered bond markets out there.”

Outstanding residential mortgage loans in Japan total over $1.6tr (EUR1.4tr, ¥180tr) as of December 2016, according to the roadshow presentation, putting it almost on a par with the UK and ahead of Australia, Canada, France and Germany in terms of mortgage market size. SMBC has a 5% share of outstanding residential mortgages, on a par with Mizuho and SMTB, with MUFG having a 7% share.

Asian covered bond issuance thus far comprises Singaporean and South Korean supply. Most recently Korea Housing Finance Corporation roadshowed a social covered bond that could be the first Korean issuance in euros, a currency in which Asian supply has been confined to Singaporean banks.