Paragon Bank debuted the first UK regulated covered bond programme based on buy-to-let collateral last week, attracting over £1.4bn of orders to a £500m FRN that Paragon’s Karen Dench said marked welcome diversification into a stable funding source for the erstwhile RMBS stalwart.

Before the global financial crisis, buy-to-let specialist Paragon predominantly funded itself through RMBS, but afterwards established Paragon Bank to build up retail funding, with securitisation contributing a diminishing share. And after drawing £2.75bn of TFSME funding, by last year Paragon had no remaining external securitisation indebtedness – which also lowered asset encumbrance levels that had been a contributing factor in preventing earlier take-up of covered bond issuance. When planning its exit from TFSME, the bank therefore finally made its move into covered bonds.

“When the RMBS market shut in the global financial crisis, we didn’t call a number of deals and had to stop lending,” said Dench, Paragon Bank’s head of markets (pictured). “Covered bonds have always been attractive in offering more stable access to markets, and also how quickly you can access the market in terms of lead time versus RMBS.”

Paragon’s move comes in spite of RMBS conditions improving and in some cases pricing beating covered bonds for UK sterling issuance in the past couple of years.

“It’s good that the RMBS market has been pretty strong,” said Dench, “but we’ve been around the block a few times and were well advanced in our covered bond thinking. We see covered bonds as a medium to long term strategy.”

Given the buy-to-let nature of Paragon’s lending, its programme would inevitably take UK regulated covered bonds into new territory, with such collateral rare across the asset class globally and only in the UK featuring in a Coventry Building Society programme that is not a regulated one.

“When we were looking at establishing the programme,” said Dench, “some banks were questioning whether or not there would be appetite, so there was a slight risk in going down this route, even if we thought it would be well received.

“However, we have a proven track record with the type of buy-to-let collateral that we originate and experience from the RMBS markets, enjoying a good reputation in secured funding, which helped. And we were pleased to see that people were willing to engage and do the work to understand the collateral.”

After flagging its broad covered bond plans in reporting last year, Paragon took soundings from investors at industry events, and then, after establishing its programme on 19 February, stepped up marketing through a non-deal roadshow at the end of February and upon the mandate announcement on 25 February.

“It was helpful for us to have front-run the debut,” said Dench, “rather than just hitting the screens and have people start looking at it from zero, and some accounts needed the time to get credit lines in place.

“Some people knew us very well, so it was more a question of providing an update,” she added, “but for others it was more of a learning curve. We received some really positive feedback, with investors happy to see a new issuer entering the market and interested in looking at something a little bit different.”

Paragon targeted launch the week after its mandate announcement, and went out with the new issue on the Tuesday (4 March).

“Markets were still pretty strong,” said Dench, “but we were mindful of headlines starting to ratchet up on the geopolitical side, so we were keen to hit the screens as soon as we could after the programme was finalised.”

Leads Barclays, BNP Paribas and NatWest opened books with initial guidance of the Sonia plus 65bp area for the March 2028 issue, and were able to tighten pricing 5bp to plus 60bp, with the order book peaking above £1.4bn for the £500m (€600m) issue.

“The outcome was fantastic, at only 10bp-12bp back of three year UK prime paper for what was an inaugural trade and the first buy-to-let UK regulated covered bond,” said a banker at one of the leads, “while it captured a nice saving versus three year RMBS.”

A level of around 65bp for such a securitisation was cited.

“The order book consisted of a number of high quality, consistent and key sterling players,” added the lead banker, “with the biggest account type being bank treasuries, as expected, closely followed by asset managers.”

Dench said the potential for involving bank treasuries was a key advantage of a buy-to-let covered bond versus a buy-to-let RMBS, with the latter not being eligible as HQLA at LCR Level 1.

“We’re clearly ecstatic with how it all went,” she added. “Ultimately, we were able to build a really strong book by following the good advice of our arrangers in terms of being a bit conservative, getting some momentum in the book, and then being able to bring the price a bit closer to where we saw relative value, with demand growing further from that stage.

“We could probably have gotten a deal away with a ‘5’ handle on it, but we took the decision to leave something on the table rather than squeeze every basis point out of the first trade, because we’re establishing a franchise and will be coming back to the market, and we’re anyway delighted about where it priced and the overall demand.”

Dench nevertheless argued that while the pick-up over owner-occupied cover pools is consistent with experience in the RMBS market, investors are receiving twofold compensation for the differences in collateral.

“There was a lot of price discovery involved,” she said, “with people clearly having different views on where it should land. We very much saw it as a question of looking at where more standard covered bonds trade and then adjusting for the collateral difference.

“But while the collateral is different, the rating agencies and the FCA have stressed it to reflect that it’s buy-to-let collateral, so the assessment has already been done. It’s always been quite frustrating for us that buy-to-let RMBS tend to price a bit closer to non-conforming RMBS, because we are a prudent lender and our collateral is really strong.”

The covered bonds are rated triple-A by Fitch and Moody’s, with the latter having assigned the programme a Timely Payment Indicator of “probable” rather than “probable-high”, as is the case for other UK regulated covered bond programmes.

Paragon’s cover pool also features greater maturity mismatches due to its buy-to-let nature and commensurate additional overcollateralisation.

“Whereas an owner-occupied mortgage is typically repayment,” said Dench, “buy-to-let is inherently an interest-only product, so you’ve got 25 year mortgages with no repayment. We managed that somewhat by blending more seasoned loans as well as new origination in the cover pool, which helped.”

With the majority of Paragon’s retail funding being easy access deposits and fixed term bonds, up to five years but predominantly one year, the issuer considered three or five year issuance with the three year maturity ultimately meeting both issuer and investor needs.

“Our thinking was that buy-to-let is exotic enough that we wanted to try to keep everything else as familiar as we could,” she added, “including the maturity of the bond. Either three or five years would have added some good duration on our balance sheet, while the curve looked quite steep between three and five years at this point in time.

“We would consider five years in future as well.”

Paragon’s documentation allows for foreign currency issuance, but a euro covered bond is not on the cards in the short to medium term, according to Dench.

“The sterling market is sufficient for our issuance plans,” she said, “but it’s clearly an option for us and we have issued RMBS in other currencies historically.

“Having gotten the first trade done, we’ll be going away and looking at what that means for our funding going forward. We’ve established the programme to access the market regularly on the covered bond side and once a year would be great.

“We will also look at RMBS from time to time,” added Dench. “It still has its positives – even if it’s more expensive, there’s less credit enhancement – and we need retained bonds on an ongoing basis as collateral for ourselves, so could supplement that with some external bonds if the pricing looks reasonable.

“And maintaining greater access to wholesale markets is something that we are strategically focused on.”