SMBC readies Japan's first covered bonds

IFR 2255 13 October to 19 October 2018 By Daniel Stanton, Tom Revell

Sumitomo Mitsui Banking Corporation is readying the first Japanese covered bond issue, but it will use an unusual structure since Japan does not have legislation for such securities.

While a successful deal could open up a huge new market for covered bond issuance, the structural differences could have an impact on demand from European investors.

The potential for Japanese covered bond issuance has been discussed for years. Shinsei Bank attempted a transaction during the global financial crisis in 2008, but the deal was postponed and ultimately failed to materialise.

SMBC announced on Thursday that it has mandated Barclays, BNP Paribas, Credit Agricole, Goldman Sachs, SMBC Nikko and UBS for the five-year euro benchmark.

Meetings will start on October 18 and end on October 24, though bankers at the leads said the deal should not be expected immediately afterwards, since investors will need time to set up lines.

Japan does not have covered bond legislation, so the €20bn covered bond programme is structured on a contractual basis. The bonds are expected to be rated Aaa by Moody’s.

“New Zealand started in a very similar way, with structured covered bonds before there was legislation,” said Claire Heaton, senior director, covered bonds product specialist Asia-Pacific, at Fitch.

“Prior to New Zealand having covered bond legislation, the investor base was quite limited. As soon as the market became regulated under specific legislation, it absolutely opened up.”

The bonds will be secured against a portfolio of residential mortgage-backed securities originated by the bank, offering dual recourse. SMBC will issue RMBS and then retain the Triple A paper for use in the covered bond portfolio. The assets will stay on the bank’s balance sheet but will be segregated in a trust.

A banker who worked on the structuring of SMBC’s programme said it also includes key features of traditional covered bonds such as a minimum overcollateralisation requirement of 25%, and an LTV threshold of 75%.

“Investors would have to look at the asset segregation method used in this covered bond programme out of Japan and decide whether the ring-fencing of those assets is legally sound, and if the bank ran into trouble whether those assets would be safe and available for bondholders as when required,” said Fitch’s Heaton.

SMBC said that, in the event of bankruptcy, it was possible an administrator could try to take over the trust or reclassify the total return swap transaction used in the exchange of cash and RMBS as a secured loan, but said it was unlikely that a court would allow it.

“However, the possibility of such re-characterisation cannot be ruled out entirely because the structure of the bonds is new to the market and, as such, there is no applicable judicial precedent,” SMBC wrote in its prospectus.

A structured finance banker in Asia questioned whether European covered bond investors would buy the paper, considering the unique features.

“They may find it does not fit into the European covered bond narrative in terms of uniformity and equivalence,” said the banker. “This looks like ABS squared.”

He noted that some smaller French banks have in the past included RMBS in their covered pools, but typically no more than 10% of the value, while South Korea also allows issuers to include RMBS, though none have done so yet. European issuers have been removing RMBS from their covered bond pools in recent years, due to changes in legislation.

“If they miss the covered bond investors, the next question is whether this is HQLA-eligible,” added the structured finance banker in a reference to high quality liquid assets. “If it is, then bank treasuries can buy it. If it isn’t, then it becomes a relative value trade.”

The unusual structure brought back memories of what was purported to be the first Chinese covered bond. In 2016, Bank of China sold US$500m of three-year bonds secured with a pledge against a portfolio of onshore bonds. BOC called the securities covered bonds, but Moody’s referred to them as secured notes.

Due to the lack of domestic legal framework, Japanese banks do not issue such instruments onshore. “Banks do RMBS instead, but they have to pay up,” said a Japanese DCM banker.

Bankers speculated whether the deal would be priced closer to covered bonds or senior unsecured debt. They said the most natural pricing comparables in the covered bond market are issues from Singapore and Australia.

(This story appeared in IFR magazine on October 13.)