Covered Bonds Make Return as BOE Curbs Bank Funding: U.K. Credit

Lloyds Banking Group Plc and Abbey National Treasury Services Plc are returning to the covered bond market as the Bank of England scales back its lending program to head off a property bubble.

Lloyds raised 1 billion pounds ($1.63 billion) from its first sale of the securities since March 2012 last week, while Abbey National borrowed 750 million pounds in its first issue in sterling in two years on Jan 13, according to data compiled by Bloomberg. The two deals exceed the 830 million pounds of bonds, which are backed by mortgages and public-sector loans, sold by U.K. banks in 2013.

The 116 billion-pound covered bond market had the worst year in its decade-long history in 2013 as the Funding for Lending Scheme gave lenders access to cash at cheaper rates. The Bank of England ended the program for household loans on Dec. 31, saying a strengthening housing market meant it was no longer necessary.

“U.K. banks had limited funding needs in 2013, but with Funding for Lending becoming less important they are looking to refresh a lot of different funding channels, including covered bonds,” said Jez Walsh, global head of covered bond syndicate at Royal Bank of Scotland Group Plc in London. RBS was among banks that arranged the transactions for Lloyds and Abbey National.

Market Peak

The Lloyds notes sold Jan. 7 pay investors 25 basis points more than the London interbank offered rate for pound loans, while Abbey’s bonds pay 30 basis points more, Bloomberg data show. Yields on sterling-denominated covered bonds fell 23 basis points to 3.4 percent this year.

The Bank of England introduced FLS at the peak of the U.K. covered bond market in 2012, when issuance reached 32.6 billion pounds, according to data compiled by Bloomberg. Abbey National, a unit of Banco Santander SA, was the only issuer of the debt last year.

The FLS, which is now focused on business lending, allows banks to raise funds at discounted rates, providing they pass on the savings. Bank of England Governor Mark Carney announced modifications in November to restrain the housing market, where prices rose 5.2 percent in 2013 amid the strongest sales in six years, according to real-estate researcher Acadametrics.

U.K. banks and building societies have 23.1 billion pounds of outstanding borrowings under the FLS, according to the latest data from the Bank of England. Under the revised terms, loans to households agreed upon in 2014 won’t gain lenders access to BOE assets.

Wholesale Funding

“It is likely that for some institutions Funding for Lending contributed to the decline of U.K. banks’ wholesale funding needs in 2013,” said Tom Ranger, director of funding at Abbey National in London. The bank may issue a further transaction in euros this year, he said.

Covered bonds were pioneered in 18th-century Prussia and issuance of the notes enables banks to cut funding costs because the securities get higher credit ratings as they’re backed by both the underlying assets and the issuer.

Germany has the largest covered bond market with 525 billion euros of debt outstanding, according to data from the European Covered Bond Council. The U.K. has the sixth-biggest market behind countries including Denmark and France.

Jumbo Bonds

Banks in the U.K. historically used asset-backed securities to securitize their debt and the market for covered notes only took off when so-called jumbo bonds of more than 1 billion euros ($1.4 billion) were introduced in 2003. Britain’s market for residential mortgage-backed bonds, the biggest in Europe, was also choked off by the Bank of England’s cheap cash, with issuance slumping to a four-year low in 2013, JPMorgan Chase & Co. data show.

“Cheap funding from the Bank of England was the main reason we have hardly seen any covered bonds over the past few years,” said Heiko Langer, senior credit analyst for covered bonds at BNP Paribas SA in London. “I don’t expect a huge wave of new supply out of the U.K. as yet, but the continued tightening of spreads on covered bonds makes them more attractive and more affordable for issuers that want to return to the market.”

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