While global covered bond issuance is enjoying a strong post-COVID-19 rebound, we expect that the current market turbulence will prove a mixed blessing for issuance outside traditional European markets. Established and highly rated issuers will probably take advantage of the current flight to quality, but banks closer to the conflict in Ukraine and new entrants will struggle to access choppy markets.

In this report, we take a closer look at the key characteristics and outlook for new covered bond markets.

Issuance Rebounds Post-COVID-19 But Clouds Are Gathering

At the onset of the COVID-19 pandemic, cheap central bank funding and the accumulation of excess savings dampened investor-placed covered bond issuance. But starting from the second half of 2021, strong inflationary pressures and easing of the COVID-19 pandemic meant that monetary policy began to normalize, leading to a sharp recovery in covered bond issuance (see "Covered Bonds Outlook Midyear 2022: The Meaning Of Higher Interest Rates," published on July 18, 2022).

Investor-placed benchmark issuance in new CEE markets slowed down significantly at the onset of the pandemic, despite new entrants from the Baltic countries, while it remained stable in Asia.

Chart 1

We expect that the most significant drivers for future issuance will be market conditions--in turn influenced by the conflict in Ukraine--and legislative developments.

Current volatile market conditions, caused by geopolitical turbulence, tightening monetary policies, and a deteriorating economic outlook, could support issuance in existing markets, especially in Asia, but dampen it in CEE, due to the proximity to the Ukrainian conflict. Established, highly rated issuers will probably use their covered bond programs more, especially if other sources of funding, such as senior unsecured bank debt, become relatively more expensive or difficult to place with investors. At the same time, market volatility may complicate issuance plans for new programs or jurisdictions. Financial institutions may not find it economical or possible to issue in times of high market volatility if, for example, they are unable to find swap providers or investor demand.

Legislative and regulatory developments will affect issuance in the medium to long term. The transposition of the European covered bond Directive into national legislations will support issuance in CEE, especially in those countries that either lacked a framework or had only an old framework that has fallen into disuse. At the same time, the creation of a European benchmark could help legislators in other regions introduce a dedicated framework or align their existing frameworks to the same standards.

Geopolitical Tensions Dampen Issuance In CEE

Covered bond issuance increased rapidly in CEE during the past decade, supported by growing mortgage lending. Even though regional banks meet most of their funding needs through retail deposits--which surged during the pandemic--covered bonds have become an important tool to finance longer term assets such as mortgages, because they reduce borrowing costs and help diversify the investor base.

Most of the regional issuance is still denominated in local currencies, especially in Czech Republic and Hungary. But euro-denominated issuance has also increased, following legislative and regulatory developments in markets like Poland, and by the debut issuance of banks located in countries that have adopted the euro, such as Slovakia and Estonia.

Chart 2

After a slow start of the year, we expect that investor-placed benchmark issuance will remain subdued over the coming months—due to slower GDP growth, headwinds from a prolonged Russia-Ukraine conflict, and higher energy prices--which are accelerating inflation and the tightening of monetary policy, both regionally and globally (see "Economic Outlook EMEA Emerging Markets Q3 2022: Slower Growth Ahead Amid Mounting Risks," published on June 28, 2022).

These factors will increase cost of living and impair loan affordability, weakening loan demand and asset performance—especially for floating-rate loans. Elevated market volatility, high yields, and abundant deposits will also deter issuers from entering the market, while uncertainty regarding economic conditions will likely reduce investor demand. Finally, we believe CEE issuers will continue to favor the issuance of MREL-eligible debt (minimum requirement for own funds and eligible liabilities), further decreasing the need for covered bond issuance.

Once economic and financing conditions stabilize and mortgage lending picks up again, we believe that issuance will return to its pre-pandemic growth trend, supported by renewed investors' appetite, asset growth, and the benefits of the transposition of the covered bond Directive.

The transposition of the covered bond Directive

The EU Directive For The Harmonization Of Covered Bond Frameworks (the Directive) entered into force in January 2020. Member states had until July 2021 to transpose it into national laws, and the new measures had to apply by July 2022. Despite the COVID-19 pandemic delaying the transposition process, most countries have now implemented the Directive into their national laws, at least partially. We anticipate that regulators will overcome the remaining hurdles in the next few months, mainly by approving the relevant secondary legislation (see "European Covered Bonds Reach Harmonization Milestone As The Journey Continues," published on July 12, 2022).

The transposition of the Directive is also largely complete in the CEE. The frameworks in established markets such as Slovakia, the Czech Republic, Poland, and Hungary have been amended, with the changes applicable from July 8, 2022. Latvia passed a new law, which was fully compatible with the Directive, in May 2021. The framework was drafted in cooperation with the other Baltic states to allow banks to combine collateral from all three countries in one cover pool. Croatia and Bulgaria passed their covered bond laws in the first half of 2022. Slovenia's covered bond law was revised in September 2021 and entered into force in July 2022. In Lithuania, the covered bond law was passed and came into force just a few days after the July 8, 2022, deadline.

The implementation of the Directive into national legislation should prove a supporting factor for covered bond issuance in the region, by either introducing new dedicated legislations or aligning existing local frameworks to the best practices of more established markets.

Table 1

Hungary

Various regulatory initiatives, aimed at reducing banks' asset liability maturity mismatch, diversifying funding sources, and establishing a green mortgage bond market, have supported covered bond issuance. The mortgage funding adequacy ratio (MFAR) regulation requires banks to finance at least 25% (30% from October 2023) of outstanding household mortgage loans with mortgage-backed bonds. By the end of 2021, about 30.6% of Hungarian residential mortgage loans were financed with mortgage covered bonds.

Various mortgage bond purchase programs by the Central Bank of Hungary (Magyar Nemzeti Bank; MNB) further supported mortgage bond issuance. As of April 2022, the MNB holds about 41% of covered bonds outstanding.

The MNB has also encouraged the establishment of a green mortgage bond market by introducing a green mortgage bond purchase program and amending the MFAR regulation allowing preferential treatment of green mortgage-backed funds. We understand that all five Hungarian mortgage loan institutions have already entered the market with green mortgage bonds in local currency, for an outstanding amount of about Hungarian forint (HUF) 156 billion.

While the conflict in Ukraine and rising inflation and interest rates have caused local issuance slowdown over the past months, we expect a moderate increase in covered bond issuance over the next year, supported by the MFAR regulation and the MNB purchase programs.

Poland

Following amendments to the covered bond law in 2016, most issuance has been euro-denominated. The accumulation of excess savings during the first two years of the pandemic depressed issuance--both in foreign and local currency--by limiting the needs for wholesale funding. While surging inflation will force households and companies to spend part of these excess savings, we believe that covered bond issuance will remain constrained in the near future. Despite a low ratio of residential mortgage loans to GDP, loan growth will moderate due to rising interest rates and the slowing economy. The Russia-Ukraine conflict has accelerated inflation and prompted the National Bank of Poland to increase interest rates to 6.5% in July 2022 from 0.5% in October 2021. Higher rates will stretch affordability for borrowers with predominantly variable loans, potentially causing an increase in nonperforming loans. Moreover, Polish banks started issuing MREL-eligible debt, with the first issuance in September 2021. As more banks follow in the coming months, covered bond issuance will be further weakened.

There are currently four active issuers in Poland, two of which also issue green covered bonds. More banks could follow once market conditions stabilize.

Czech Republic

The Czech covered bond market is the largest in the CEE region, even though most of the local mortgage lending is funded by customer deposits. Most of the Czech issuance has been in Czech koruna, except in 2020 due to a large euro-denominated retained bond. Czech banks have recently increased the volume of euro-denominated loans granted to corporate entities, driven by close trade ties to the Eurozone and interest rate differentials between euro and Czech koruna, and they now represent about 15% of the total lending. This may lead to an increase in euro-denominated covered bonds once market conditions stabilize.

We expect covered bond issuance to remain subdued over the next months. In an effort to contain high and rising inflation, the Czech National Bank (CNB) hiked rates from almost zero during the pandemic to 7% by June 2022. The rise in interest rates has been detrimental to consumer confidence and spending appetite, and it is slowing down the previously burgeoning housing market. The CNB's recent tightening of macroprudential measures, such as the reintroduction of limits on debt-to-income and debt service-to-income ratios in April 2022, and the ongoing rise in interest rates will likely further slow the growth in mortgages. While we expect that part of the excess saving accumulated during the pandemic will be spent, the slowdown in asset growth will limit banks' wholesale funding needs.

Slovakia

Slovakia's covered bond market has grown rapidly over recent years following updates to its legislation in 2018.

Mortgage lending has risen quickly, supported by climbing residential property prices and funded primarily with low-cost customer deposits. However, following updates to the legal framework in 2019, banks have used covered bonds to optimize borrowing costs and match the duration of their mortgages with long-term funding.

Slovakian issuers have remained active so far in 2022 with two euro benchmark issuances, which brought the 2022 benchmark issuance from the country at par with the 2021 level.

Legislative Developments Will Drive Issuance Outside Europe

Covered bonds are poised to play a greater role in mobilizing private capital toward mortgage financing outside Europe, with significant differences between developed and developing markets. Emerging markets have the greatest growth potential, due to the expected expansion of mortgage financing, but they also face formidable obstacles.

A major impediment to the development of covered bonds in new markets is the lack of dedicated legal frameworks, and experience shows that the legislative process can be complex and time consuming. Despite the success of the first Japanese issuance, we don't believe that many financial institutions outside this country will establish programs based entirely on a contractual framework. Most potential new issuers will wait for the approval of a dedicated covered bond legal framework, or at least an appropriate supportive regulatory framework, in our view. At the same time, we are encouraged to see that a growing number of regulators, in China and India among others, are considering the product. And if it proves successful in Brazil, we expect to see similar legislative initiatives in other parts of Latin America.

Table 2

Regulatory development could also support issuance, even where a dedicated framework exists. First, asset encumbrance limits, which constrain volumes by capping the amount of banks' assets that can be included in cover pools, can be revised. For example, in 2020 the Monetary Authority of Singapore increased the asset encumbrance limit to 10% from 4% of the issuer's total assets. This could lead to an increase in existing programs' sizes and might incentivize new banks to establish programs. Second, loss-absorbing rules can favor covered bonds over other debt instruments: in Europe, covered bonds are exempt from bail-in, while senior unsecured debt is not. Similar regulation can be introduced elsewhere, making covered bonds more attractive for investors. The resolution regime that came into force in Canada in 2018 excluded covered bonds from bail-in, confirming the favorable regulatory treatment enjoyed there. Third, under the EU Capital Requirements Regulation, European covered bonds benefit from a preferential risk weight treatment. The latest round of Basel reforms could lead to other countries, such as Australia, Korea, and Singapore, providing for a similar preferential risk weight treatment for local covered bonds.

Table 3

Asian Issuance Set To Grow Despite Abundant Liquidity

Korea and Singapore pioneered covered bond issuance in developed Asia. As customer deposits primarily fund local banks, their main motivation in establishing covered bond programs was to manage asset liability mismatch risk and diversify their funding sources. In 2018, the first covered bond program was set up in Japan. Because there is no dedicated local covered bond legislation, the program was based on a contractual structure.

Despite a surge in liquidity following the COVID pandemic, Asian banks remained active in the covered bond market, a testament to the strategic importance that the product plays in their funding strategies.

Chart 3

We expect that issuance in developed Asia will be restrained by the availability of customer deposits, limited funding needs in foreign currencies, and weak loan growth. The stimulus for further issuance will probably come through legislative and regulatory initiatives. We see a greater growth potential in developing Asia, where we expect that housing finance needs will grow substantially, but legislative developments will be essential.

South Korea

Covered bonds in South Korea can be issued through the Covered Bond Act and the Korea Housing Finance Corp. Act. The Korean Housing Finance Corp. (KHFC) has issued covered bonds since 2010, joined by Kookmin Bank in 2015 (see "How We Rate Korean Covered Bonds," published on May 20, 2019). Since then, KHFC issued the first social covered bond from Asia and the first Korean euro-denominated covered bond in 2018, and KEB Hana Bank established its own program and inaugural euro-denominated issuance in January 2021.

The Korean Financial Services Commission a few years ago adopted several measures to encourage covered bond issuance, including reduced registration fees for bond issuance and lower capital requirements for covered bond investors. These measures incentivized the issuance of South Korean won-denominated bonds, and since 2019 five financial institutions, including KHFC, have issued covered bonds in the domestic market.

We expect Korean issuers to continue using covered bonds, both domestically and internationally, to diversify their funding base and mitigate asset-liability risk.

Singapore

The regulatory framework for the issuance of covered bonds by banks incorporated in Singapore was established on Dec. 31, 2013, and refined on June 4, 2015, through the Monetary Authority of Singapore (MAS)'s Notice 648 (see "Singapore's Covered Bond Framework Supports Higher Ratings On Covered Bonds Than on The Issuer," published on Feb. 23, 2016).

With the legislative framework in place, the three major domestic banks have already set up their programs and issued cumulatively the equivalent of more than €14 billion as of mid-2022. The increase in asset encumbrance limit to 10% from 4% of the issuer's total assets since October 2020 has provided more headroom for further issuance. However, the overall supply will likely be limited because banks in Singapore are mostly funded by depositors and have limited funding needs in foreign currencies.

Japan

Covered bond issuance is possible according to a dedicated legal framework--"legislation-enabled" covered bonds--or through contractual means--"structured" covered bonds (see "S&P Global Ratings' Covered Bonds Primer," published on June 20, 2019). Since there is no dedicated legal framework in Japan, when Sumimoto Mitsui Banking Corp. (SMBC) issued the first Japanese covered bond in November 2018 it based its program on a contractual structure. Likewise, Sumitomo Mitsui Trust Bank (SMTB) launched its inaugural covered bonds in October 2020 with a structure similar to SMBC's. Given the availability of domestic deposit, it appears that the main reason for establishing covered bond programs is to attract cheap foreign currency funding.

The Japanese covered bond market has the potential to grow quite considerably. Local lenders are already using collateralized lending, such as residential mortgage-backed securities (RMBS), and they have now started adding covered bonds to their funding mix; outstanding mortgage loans are around ¥200 trillion, of which only 15%-20% is currently used as collateral for RMBS, leaving ample capacity for covered bond issuance; Japanese banks have considerable assets denominated in foreign currencies and covered bonds could constitute a competitive source of funding for these assets; and from a risk and regulatory perspective, covered bond issuance can reduce the duration mismatch between the assets and liabilities (see "How We Rate Japanese Covered Bonds," published on Sept. 6, 2019.)

However, the current lack of a dedicated legal or regulatory framework could be a restraining factor for further issuance, especially for regional banks.

China

On May 26, 2022, the National Association of Financial Market Institutional Investors (NAFMII) announced a pilot program for covered bonds. The main goal of the notice is to support projects relating to affordable housing and low-rent homes.

NAFMII sets out requirements for the registration of covered bond programs, use of proceeds, and information disclosure. Eligible underlying assets include property and land-use rights, while chattels and intangible assets may also be designated as eligible asset classes in the future.

Compared with auto asset-backed securities and RMBS, the transaction structure of domestic covered bonds is more flexible. Asset segregation can be achieved either through the true sale of assets to a special-purpose entity (SPE) or pledge of covered assets.

Following the rollout of the guidelines, the first self-labeled domestic covered bond was issued in the interbank market in late June 2022, backed by the operating income of a hotel property. In our view, there are still legal and structural hurdles to overcome before covered bonds are issued in China in line with international practices.

Generally speaking, issuers in China have expressed increased interest in dual-recourse issuance in the past few years. Since larger banks benefit from abundant liquidity and strong deposit bases, the appetite for covered bonds mainly reflects increasing risk awareness--specifically, the importance of having alternative tools for banks to plan for rainy day funding, rather than current funding needs. Aside from limited issuers' supply, there are several other legal and regulatory questions that should be considered. The incumbent asset issue is a primary challenge for covered bond issuance. China has regulations on the protection of depositholders, and the arrangement to ringfence specific banks' assets to benefit covered bondholders could be complicated without a dedicated legal framework. Moreover, legally, depositholders enjoy a very high ranking in the allocation waterfall after banks' liquidation in the region. Because these assets' ringfencing and deposit ranking relate to the sovereign banking laws, regulators may find it difficult to have flexibility, even if they support the development of covered bond issuance. Finally, it is unclear whether an on-shore SPE could validly provide a guarantee for payments.

India

India has a significant shortage in affordable housing and a young and growing population. Moreover, household debt as a percentage of GDP is below that of other emerging markets. These factors suggest there could be significant growth in the housing finance sector in the future. Currently, customer deposits are Indian bank's primary source of funding, but issuers and regulators are considering alternative sources of wholesale funding, including covered bonds. The Reserve Bank of India (RBI), for example, constituted in 2019 a Committee on the Development of Housing Finance Securitisation Market, which recommended, among other things, an enhanced role for the National Housing Bank and further amendments to reduce the transaction costs for securitizations. Like other Commonwealth countries such as Australia and the U.K., India does not have specific legislation governing securitization. Rather, the legal framework for India's securitization market is based on existing trust, contract, and property law, and a series of guidelines issued by the RBI. We anticipate that if covered bonds are issued in India, they may at least initially be issued under a general-law framework with an appropriate supportive regulatory framework. In our view, key clarifications required will include whether the issuance of covered bonds is permitted under Indian legislation generally, whether existing securitization guidelines can be applied to covered bonds, how asset segregation can be achieved, the treatment of assets in an issuer insolvency scenario, and whether there are any challenges from a tax perspective, including stamp duty and withholding tax (see "India's Pathway To Establishing A Covered Bond Market," published on Sept. 12, 2017).

Latin America

Covered bonds in this region have a short and limited track record. Panama was the first country to see a covered bond issuance in October 2012. Since it does not have a dedicated legal framework, covered bonds were based on contractual agreements. Chile also saw limited and locally distributed covered bond issuance in the past.

One factor preventing financial institutions in the region from issuing covered bonds was the lack of a dedicated legal framework. However, things are changing thanks to the legislative developments in Brazil. If covered bonds prove successful there, we may see other countries in the region follow its lead.

Brazil

In October 2014, Brazil enacted Provisional Measure No. 656, which outlined a framework for Brazilian local covered bonds ("letra imobiliária garantida"; LIGs), and which became Law No. 13,097 in January 2015. From the standpoint of the legal protection afforded to covered bondholders by the Brazilian framework in case of issuer insolvency, we believe the new regime could allow a covered bond program to be rated above the issuer credit rating under our covered bonds criteria (see "A Closer Look At The Brazilian Covered Bond Framework," published on Dec. 6, 2016).

Banks only began issuing LIGs after the presidential election of 2018, with private domestic placements. At the end of 2020 the Brazilian Securities Exchange Commission allowed public placements for LIGs, which could further support domestic issuance. The market is still waiting for legal and regulatory clarification on how international issuances could be done. Once this clarification is obtained, we believe that Brazilian banks will try to issue LIGs offshore targeting foreign investors.

Africa

Morocco was the first country in the region to release draft covered bond legislation (see "Morocco Looks To Covered Bonds To Support Housing Finance," published on May 8, 2013). However, it has not yet approved the final law, which is a testament to the difficulties a legislative process may encounter.

Similarly, in 2015, South African regulators considered allowing banks to issue covered bonds, in the context of a broader discussion regarding resolution regimes and the anticipated introduction of retail depositor guarantees. However, domestic investors remain resistant to the idea of covered bonds, due to their concerns about the potential pressure on the pricing of their senior unsecured debt, the losses if an issuer becomes insolvent, and what could happen to the ratings on this debt. As of today, banks are still not allowed to issue covered bonds, and we don't expect any market development in South Africa in the near future.

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