Arranging Japan’s First-Ever ‘Covered Bonds’

Published on20 MAY 2019

The article below is from our BRIEFINGS newsletter of 20 May 2019

When raising funds outside of Japan, Japanese national banks are often forced to pay higher costs than their foreign peers who can utilize secured funding. But Goldman Sachs worked on a solution for long-time client Sumitomo Mitsui Banking Corporation (SMBC) by serving as lead arranger and lead left book runner on an inaugural EUR 1 billion covered bond in October 2018. The covered bond – which was part of a EUR 20 billon funding package – is the first of its kind in Japan. We sat down with Yusuke Minowa and Eldar Mezbur of the Investment Banking Division to discuss the transaction.  

Can you explain the context of the funding environment in Japan? Why are banks typically forced to pay higher costs than their foreign competitors? 

Yusuke Minowa: SMBC has been rapidly expanding its overseas business since the financial crisis. Traditionally, Japanese financial institutions have used customer deposits or issued corporate bonds to fund their overseas operations. But this has put them at a disadvantage to their international peers. That’s because they have typically had to shoulder higher funding costs due to the unsecured nature of these sources, and because Japan’s relatively lower sovereign credit rating has a knock-on impact on corporate issuers’ ratings. In an annual policy report published in September last year, Japan’s Financial Services Agency warned that the country’s major banks need to secure foreign-currency financing to withstand abrupt changes in economic and market conditions as they expand abroad. As we searched for a solution to help level the playing field for these clients, we explored whether we could leverage the assets on their massive balance sheets. Japanese financial institutions possess large portfolios of residential mortgages with some of the lowest delinquency rates in the world. It was then that we hit on the idea of a Japanese covered bond.

Eldar Mezbur: Originally developed in Europe, covered bonds are debt securities issued by financial institutions and backed by a separate pool of assets – the “cover pool” which usually consists of residential mortgages – that are ringfenced from bankruptcy proceedings. So, if an issuer defaults, bond holders have a priority claim on the cover pool; if the pool of assets are insufficient, they are also able to claim against the issuer directly – something known as “dual recourse.” The additional security translates to a higher credit rating and lower coupon than regular corporate bonds. But there was a big hurdle: no Japanese entity had issued a cover bond because the necessary legal framework simply did not exist.

That’s a pretty big hurdle. How did the team solve it?

YM: Previous attempts to create covered bond structures in Japan floundered precisely because they sought to replicate the mechanisms used in other markets. By contrast, we focused on finding an innovative structure to deliver the benefits of a covered bond within the existing legal framework, using contract law and derivatives.

EM: Beginning in late 2016, we spent almost six months travelling across Europe and talking with more than 100 investors, ratings agencies and trust banks to gauge the investor appetite and the market for covered bonds from Japan. Client feedback helped us refine the idea, and ultimately get our outside legal counsel comfortable with the structure.

What was the impact of the transaction?

EM:  Using this structure, SMBC was able to sell this debt at an interest or “coupon” rate 50 percent lower than their previous senior unsecured bond issuance. So the bank was able to both lower its cost of funding while diversifying its investor base.

YM: The transaction was supported by a broad range of traditional covered bond investors, who tend to prefer high quality debt and have a long-term investment horizon. Asset managers were the biggest group of investors in the bond, for example, accounting for 42% of the total. Central banks and official institutions were also well represented, as the second biggest investor type, despite the absence of dedicated covered bond legislation. Both groups were relatively new investor types for SMBC, and this diversification should offer a new level of stability to the bank’s foreign currency funding.

Tell us a little bit about the covered bond market globally.

EM: The covered bond market is relatively nascent in the US, but these bonds are issued regularly in 23 countries globally, including much of Europe as well as Australia, Canada, New Zealand and Singapore. While the market is still dominated by European offerings, non-European issuance is growing. A number of countries in Asia Pacific, including South Korea and New Zealand, initially allowed covered bonds structured under contract law, before introducing dedicated legislation. Investors are now watching to see whether Japan will follow the same path, and open the door even wider for this new asset class.