SMBC contractual offering unlikely to put Japan on covered bond map

Having fallen behind Singapore and South Korea, which both have approved formal covered bond laws, is the timing of Japan’s inaugural covered bond sensible?

Viewpoint
Keith Mullin
Keith Mullin

Interesting to see that Sumitomo Mitsui Banking Corporation has mandated banks for what could become Japan's inaugural covered bond. The megabank goes on the road for a week commencing October 17 for what, barring negative market events, will emerge as a five-year euro benchmark.

SMBC has established a 20 billion euro covered bond programme. Goldman Sachs and SMBC Nikko are lead arrangers; Barclays and BNP Paribas are arrangers, with Credit Agricole CIB and UBS acting as dealers along with all of the others. All banks have been appointed as joint bookrunners on the inaugural trade.

Moody's assigned a provisional long-term rating of (P)Aaa to the issue on October 12, based on minimum over-collateralisation of 25% and a series of positive credit and structural factors. However, for the purists out there – and if any market has them it's the covered bond market – the fact that the issue will come in contractual format is a big deal and will set the issue aside from 'real' covered bonds.

The prospectus makes the difference crystal clear: "Although the bonds to be issued under the programme share many of the characteristics of typical 'covered bonds' and have contractual recourse as a form of 'contractual covered bond' … prospective investors should understand that the bonds do not constitute 'legislative covered bonds' for the purposes of any law or regulation in any jurisdiction and therefore should not be regarded as such for any such purposes by any person".

Issuers have come to market over the years with a range of contractual or structured covered bond lookalike formats; sometimes with non-traditional assets (SME loans) and often melding aspects of securitisation structuring technology. To that point, SMBC's prospective offering will be secured on a dynamic pool of self-originated Japanese law senior RMBS tranches, which can be substituted throughout the life of the issue by the total return swap counterparty (which is also SMBC).

The core covered bond community, however, has typically been very wary of innovative issuance and has been at pains to avoid having novel formats pollute the sanctity of legislative covered bonds. Regulators have given covered bond preferential regulatory treatment and covered bond participants are extremely keen that such treatment remains in place and can therefore be justified.

The fact that Japan doesn't have a covered bond law is an issue for the world's third largest economy. Bankers, investors, regulators and Japanese politicians have been talking about covered bonds for a considerably long time. In fact, it's just over 10 years since Shinsei Bank attempted the country's debut structured covered bond. They say timing is everything: pushing a new concept for Japan into the market in the eye of what became the global financial crisis ultimately proved the deal's undoing and it never saw the light of day.

Over the years, there have been had any number of working groups, gatherings and reports convened by the likes of the Ministry of International Trade and Industry and Development Bank of Japan, but any momentum behind a formal covered bond law seems to have stalled under the Abe administration. A Japanese covered bond law, which would allow both for mortgage as well as public sector loan refinancing, would properly put Asia on the covered bond map.

In prevaricating for such a long time, Japan has fallen years behind Singapore and South Korea, which both approved formal covered bond laws that became effective in 2015. Since then, the countries' banks have made good use of the instrument across various currencies and markets, including US dollars, euro, pound sterling and in kangaroo format.

The Singaporean banks have been particularly active this year, with DBS, UOB and OCBC all issuing throughout 2018. In fact, the country's banks continue to apply pressure to the Monetary Authority of Singapore to relax the cap of 4% (minus mandatory deductions) of total assets imposed on the amount of collateral allowed in cover pools, in order to allow issuance levels to expand. This is not so much an issue for the big three; more so for the smaller domestic banks and subsidiaries of foreign banks which have smaller balance sheets so are unable to issue in the size required by the institutional market for liquidity and other purposes.

The reasons covered bonds are so popular with issuers and investors is they can offer issuers fabulous funding advantages given their preferential regulatory treatment. Investors, meanwhile, are happy to pay up to buy an instrument with dual-recourse security features – i.e. to the assets and the issuer – and one which has been pretty robust from a performance and default perspective.

In difficult markets where there are access pressure points in other primary segments, covered bonds tend to remain open for longer and suffer lower spread volatility.

It'll be enlightening to see if conservative core European covered bond investors take to SMBC's issue. It will certainly fall outside the scope of some. A real point of interest is whether the bonds will price in the covered bond neighbourhood (sub mid-swaps for core jurisdictions) or are pushed closer to senior unsecured territory.

In a very twitchy credit market, it's likely to be a bit of a moveable feast. In fact, if markets fail to stabilise, the bank may be better advised to wait.