Covered bonds are debt instruments that are generally issued by financial institutions and secured by a cover pool of high-quality assets held by a special purpose vehicle (SVP) which guarantees repayment of the covered bonds if the issuer defaults on the bond payments. Covered bonds are common internationally and have also become a significant funding source for Canadian banks, with all the Schedule I banks establishing a covered bond program and issuing one or more series under such program. To date, total issuances of covered bonds by Canadian financial institutions exceed $30 billion.
At this time, there is no legislative framework governing the issuance of covered bonds in Canada, and each of the current Canadian programs has been established under a contractual framework. This non-legislative, contractual approach suffers from two drawbacks: i) it makes the Canadian covered bond market less robust compared to those jurisdictions in which a legislative framework exists, as it reduces the ability of Canadian financial institutions to diversify their funding sources since many investors are restricted from purchasing covered bonds for which no legislative framework exists; and ii) the assurance by an issuer of repayment in the event of default is not as robust as if that assurance is enshrined in legislation.
The Federal Department of Finance (the Government) has issued a consultation paper regarding a proposed legislative framework for covered bonds in Canada. Some of the key elements are as follows:
Insolvency Protection - The Government proposes the legislative framework clarify that in the event of issuer insolvency, the covered bondholders have priority of claim over the assets held by the SPV. The Government also proposes to protect the priority of service providers in the event of the insolvency of the SPV. While the current programs have been structured in a manner that is meant to ensure such priorities, the certainty afforded by a statutory regime is desirable to many of the participants in the programs.
Permitted Assets - The Government proposes that the legislative framework will only permit loans made on the security of a residential property located in Canada to be included in the cover pool, unlike in other jurisdictions in which a broad range of assets may form the collateral for covered bonds. To date, all Canadian covered bond programs include only Canadian residential mortgages in their collateral pool.
Permitted Issuers - The Government proposes that the legislative framework be available to federally regulated financial institutions (FRFI) only. Non-FRFIs would be able to benefit from the framework by selling eligible assets to FRFIs.
Overcollateralization - Overcollateralization is the amount by which the value of cover pool assets is required to exceed the value of the covered bonds issued. A higher level of overcollateralization serves as a credit-enhancement for the covered bonds, but diminishes the amount of assets available to other creditors and depositors of the issuer. Under current Canadian practice, issuers generally set the maximum overcollateralization at 10 percent. The Government proposes that the legislative framework standardize current Canadian practice and set a maximum level of overcollateralization.
What happens to existing issuances? - The Government proposes that, subject to the approval of the proposed covered bond registrar, existing covered bonds programs could become registered programs if the issuer becomes a registered issuer and the program otherwise complies with the legislation.