Canada’s federal budget tomorrow (Thursday) is widely expected to be accompanied by news on covered bond legislation, with market participants anticipating how a possible ban on Canada Mortgage & Housing Corp insured mortgages in cover pools would affect supply and spreads.

Five Canadian issuers have raised more than US$12bn (Eu9bn/C$11.9bn) in aggregate through covered bond issuance so far this year, amid record supply of US dollar denominated covered bonds. All of the Canadian supply has been from issuers using collateral insured by CMHC that observers believe could be prohibited, with the Canadian authorities seeking to rein in recent strong growth in the crown corporation’s activities that has accompanied growing fears about the sustainability of house prices.

CIBC and Royal Bank of Canada have not tapped the benchmark covered bond markets this year, with RBC – the only Canadian issuer not to have gone down the CMHC route but used uninsured prime residential mortgages – not having done so since April 2010. Rating agencies have recently noted that CBIC appears to be near a 4% cap on issuance relative to total assets set by OSFI.

A syndicate official said that Canadian covered bond spreads have tightened in anticipation of CMHC-insured assets no longer being allowed as collateral for covered bonds, while another spoke of there being a “race” to see who will be the first to issue under such a new framework and RBC expected to be “first out of the gates”. However, he said there would be some “downtime” after legislation details are announced, while a lawyer suggested that Canadian banks could have to spend some time restructuring programmes.

A supplemental prospectus to Bank of Nova Scotia’s programme released in January has also raised the prospect of outstanding CMHC-backed covered bonds being exchanged for new legislative covered bonds with uninsured collateral – although several market participants have said they expect grandfathering of outstanding issues to make this unnecessary.

Bank of America Merrill Lynch analysts earlier this month said that they believe Canadian banks’ issuance capacity would remain unchanged if new covered bond legislation were to exclude insured mortgage loans from making up cover pool assets, because they are not short of uninsured loans. They stated that insured mortgages at RBC represent 20% of the total compared with around 50% for Bank of Montreal and 60% for CIBC and Toronto-Dominion Bank.

BAML’s analysts said that new Canadian covered bonds without the backing of CMHC-insured assets would not price significantly wider, given the spread differential between RBC covered bonds and those of its peers.

“The differential between the two types of covered bond has been 11bp on average, with a maximum of 20bp and a minimum of minus 3bp,” they said. “This is in line with what we see in other covered bond markets where the spread differential between public sector and mortgage covered bonds in core markets for prime collateral is typically limited.”

They also attributed a tightening of dollar Canadian covered bonds since the beginning of the year to a general market rally rather than to any change in permissible eligible collateral.

A syndicate banker expressed some scepticism about some of the points made by the analysts, saying that it would take some time for Canadian issuers to originate new collateral eligible for issuance under a new covered bond framework in the country, and that the CMHC insurance has a pricing relevance.

RBC is the only Canadian issuer to sell covered bonds backed by assets without CMHC insurance, and the banker put the spread on the bank’s April 2010 issue at around “double digits” back of covered bonds from its peers, but noting that the 2010 deal is not that liquid.

He said that the CMHC insurance backing most Canadian covered bond collateral has meant that there is a large investor base viewing it as quasi-public sector debt, which allows tighter pricing and an allocation to different risk categories, with implications for ticket sizes.

However, Canadian covered bonds would still represent high quality collateral from high quality issuers even if CMHC-insured pools become a thing of the past, he said.