Securitization got a big black eye in 2008, especially here in Canada where legions of investors (including some of Canada’s top pension funds) got burned by exposure to asset-backed commercial paper (ABCP).
Tainted by a hint of subprime mortgage exposure in a few of the ABCP trusts, the entire market froze in August 2007. Investors who thought they had a lock-tight AAA investment were left holding large quantities of valueless paper.
While ABCP has been virtually wiped off the Canadian map, the notion behind it wasn’t half bad – AAA-rated investments based on steady streams of loan payments sure seem like a good option for parking cash, especially given the state of the government bond market today.
Which is why the covered bond market is getting a bit more attention these days, especially in the ETF space where ProShares has launched the first ever U.S. covered bond ETF with dollar-denominated covered bonds from non-US banks.
Covered bonds, like ABCP, offer investors exposure to cash flows from a pool of loans (i.e., mortgages, public sector loans). All of the underlying assets remain on the balance sheet of the issuing bank, meaning the issuer has skin in the game (unlike Canada’s non-bank ABCP). They’re collateralized at just over 100% as an extra layer of security and if anything happens to the issuing bank, covered bond investors are first in line to get their money back (not the case during the ABCP crisis when even owners of bank-sponsored paper weren’t sure who was supposed to pay up in the end).
According to Institutional Investor, the new ProShares ETF has only $13 million in assets but most of the 36 covered bonds in the portfolio are from Canadian banks. That is because Canada is still AAA-rated — a crucial factor in the covered bond market. Issuing banks have to be from countries with a AAA rating (a tough thing to find these days).
At just $13 million, the covered bond ETF is still very small. But it’s a sign that investors are still looking for better yield without the high default risk. As more investors them out, it could be a boon for Canadian banks looking to ride the wave of Canada’s high rating.