In this report, we take a closer look at the issuance outlook, regulatory and legislative developments, and key characteristics of covered bond markets in Central and Eastern Europe (CEE), Asia, Latin America, and Africa.

Global Issuance Remains Close To 2023 Record Levels

Global investor-placed benchmark issuance exceeded €75 billion in the first three months of 2024 (see chart 1). Despite fewer covered bond redemptions and lower central bank funding repayments than in 2023, we expect issuance to remain strong in the rest of 2024, supported by lower interest rates that will prop up mortgage lending.

Chart 1

The EU's harmonization directive--which introduced a common definition of covered bonds across Europe--has not yet led to issuance in EU countries that previously lacked dedicated legislation, such as Croatia and Bulgaria. In CEE, ample liquidity is disincentivizing the issuance of covered bonds. Slovakia remains the most active regional player in the euro benchmark segment, but other countries have a vibrant local-currency market (see charts 2 and 4).

Chart 2

Despite a surge in liquidity following the COVID-19 pandemic, Asian banks remain active covered bond issuers. While Korean and Singaporean banks still dominate, regulatory developments could encourage new issuers to enter this market (see chart 3). Moreover, European authorities could, in future, decide to grant equivalent treatment to covered bonds issued by credit institutions outside the European Economic Area (see "Covered Bonds In New Markets: A Shifting Paradigm," published on May 24, 2023). This could support issuance in Asia and beyond.

Chart 3

Regulatory issues still constrain the foreign-currency issuance of Brazilian covered bonds, but we understand that regulators are considering changes to address this. In 2022, Morocco approved the first covered bond legislation in Africa. Local authorities are still working on the secondary legislation, which we expect them to approve this year.

Regional And Country Focus

Central and Eastern Europe

Euro benchmark covered bond issuance in CEE stood at €4 billion in 2023, its highest level in the past ten years. This was despite macroeconomic challenges from ongoing geopolitical conflicts and tight monetary policy conditions aimed at suppressing high inflation. However, the picture is largely divided between Slovakia and the rest of the CEE countries. Slovakia--being part of the eurozone--continued to issue the most in 2023, following a similar strong dynamic to that in more established markets (see "Global Covered Bond Insights Q1 2024: Issuance Still Strong As Market Exits Central Bank Funding," published on Dec. 15, 2023). Slovakia also issued the first benchmark covered bond in CEE of 2024.

However, Slovakia aside, overall activity in CEE in 2023 has been muted due to banks' ample customer deposit base, weaker loan growth, reduced investor appetite, and banks' focus on issuance to meet the minimum requirement for own funds and eligible liabilities, which has been legally binding since Jan. 1, 2024. There has also been limited activity in the Czech Republic, which saw the issuance of the first green mortgage covered bond in the country in June 2023.

Generally, excluding Slovakia, CEE euro benchmark issuance remains fairly limited. Covered bond issuances are mainly in local currencies, particularly in the Czech Republic, which has the largest covered bond market in CEE by outstanding volume, and in Hungary, whose covered bond market remains wholly domestic (see chart 4).

Chart 4

Looking ahead, we believe that CEE investor-placed benchmark issuance will pick up only gradually over the next year. Economic conditions have stabilized in most of CEE thanks to falling energy prices. These have helped lower inflation and reduce external deficits as regional exchange rates have recovered and government bonds normalized (see "Central And Eastern Europe Banking 2024: Solid Performance Buffers Mounting Risks," published on Nov. 21, 2023).

Central banks in CEE were generally more aggressive in their response to the sharp increase in inflation in 2022, but have already started to cut policy rates. With rate cuts under way, the costs of new loans will start falling. This should pave the way for a rebound in borrowing activity, supporting growth. At the same time, the decline in real house prices over the past two years, government measures to support loan growth, as well as the relaxation of macroprudential policies in some CEE countries, should support housing affordability. Low CEE household indebtedness and a tight labor market should aid residential mortgage loan performance. All of the above factors should support covered bond issuance and investor demand in the region. That said, an ample customer deposit base will limit banks' wholesale funding needs.

Chart 5

Table 1  |  View Expanded Table

Czech Republic.  Covered bonds are a material funding source for the Czech financial system, representing around 49% of bank capital market funding as of year-end 2022. The Czech covered bond market is predominantly domestic and remains the largest in CEE. However, it has contracted substantially of late, with outstanding volumes 21% lower at year-end 2022 than at the end of 2021.

The decline in lending for house purchases that started around mid-2022 significantly reduced loan demand. The decline was the result of a rise in mortgage rates to close to 6.0% for new loans amid the Czech National Bank's interest rate hikes, and policymakers' tightening of macroprudential policies at that time. This, together with the availability of a strong and resilient client deposit base, resulted in limited funding needs for banks. The loan-to-deposit ratio of 67% at year-end 2023 (down from 71% in the prior year) is the lowest among peers.

Euro benchmark issuance in the Czech Republic has been limited. In 2023, one issuer tapped the market twice and in June 2023, the first green mortgage euro benchmark covered bond was issued in the country. The issuance proceeds are dedicated to eligible green buildings, namely, single and multifamily houses within the mortgage cover pool. The cover pool contains loans secured on properties in the Czech Republic and Slovakia in both Czech koruna and euros.

We expect subdued covered bond issuance in 2024, along with a gradual recovery of loan growth. Support for growth will come from the stabilization of interest rates, albeit at a higher level; a slow decrease in inflation; and the Czech National Bank's recent relaxation of macroprudential policy instruments. The Czech National Bank lifted the debt service-to-income upper limit in July 2023 and the debt-to-income upper limit in January 2024, while reducing the countercyclical capital buffer from its 2.5% peak rate to 1.75% currently. We believe that the persistence of higher interest rates than in the eurozone and limited alternative domestic investments for clients will keep banks' deposit volumes high, limiting their funding needs.

On the other hand, the importance of foreign-currency lending to domestic nonfinancial corporations in the Czech Republic has long been increasing. Euro-denominated loans constituted close to 50% of the total outstanding amount of domestic banks' loans to nonfinancial corporations in the third quarter of 2023, increasing banks' euro funding needs. Covered bonds could become an attractive source of foreign-currency funding and enhance the currency diversification of funding sources if other sources to obtain foreign currency such as cross-currency swaps become less attractive.

Hungary.   Outstanding covered bonds in Hungary reached €4.8 billion as of 2022, slightly above the amount in 2021. Hungary's covered bond market is wholly domestic, and its dynamics reflect regulatory initiatives. These include a mortgage funding adequacy ratio (MFAR) that requires banks to finance at least 25% of their outstanding household mortgage loans with mortgage-backed bonds, and the previous mortgage bond purchase programs of the Central Bank of Hungary (Magyar Nemzeti Bank or MNB), which it discontinued in 2022.

Since July 2021, green mortgage bonds have received preferential treatment in the MFAR calculation, which together with the MNB's previous Green Mortgage Bond Purchase program, have resulted in an increase in the share of green mortgage bonds. By year-end 2022, green mortgage bonds represented about 8% of the total mortgage bond stock. Since July 1, 2022, foreign-currency mortgage bonds have been eligible under the MFAR requirement, but we understand no such issuances have occurred yet.

The MNB's planned MFAR tightening measures aimed to apply from Oct. 1, 2023, including an increase to 30%, restrictions on cross-ownership of mortgage bonds by banks and required stock market listing, remain postponed indefinitely amid uncertain economic and capital market conditions. Furthermore, in September 2023, the MNB postponed the green requirement that it had envisaged would apply to new foreign currency mortgage bonds from Oct. 1, 2023, by one year.

As of the end of June 2023, the MNB held around 32% of the stock of mortgage bonds, domestic banks 51%, and domestic institutional investors around 9%, and foreign investors around 7%. The MNB only maintains its mortgage bond rollover facility for maturing covered bonds subject to certain terms and conditions.

We expect covered bond issuance to remain subdued for the rest of the year. The average banking system MFAR was around 32% at the end of June 2023, providing a buffer above the 25% minimum. A larger volume of mortgage bonds matures in 2024, driving domestic issuance needs together with expectations of mortgage loan growth. Some banks may also find it challenging to maintain MFAR compliance in the current market conditions. While green mortgage bond issuances would help banks meet the MFAR requirement, there are limitations due to challenges regarding data-gathering for green mortgage loan qualifications and the availability of sufficient suitable green mortgage loans.

Loan growth stabilized around 9% in 2023, thanks to the government's subsidized loan programs, the capping of interest rates, and monetary policy rate cuts. We expect loan growth to continue to expand during 2024, although forecasts greatly depend on Hungary's economic growth and the subsequent return of domestic demand, as well as government measures, which have supported loan growth significantly in the past.

We don't expect foreign currency-denominated issuances in the short term due to the complexity of preparing such issuances, which would also require the arrangement of hedging agreements, and possible challenges in achieving a critical mass of issuance volumes appropriate for international markets.

Poland.   Polish covered bonds play a modest role as a funding source for the Polish banking system, representing around 6% of bank capital market funding in 2022. Since the outbreak of the COVID-19 pandemic, Polish covered bond issuance has decelerated with 2022 year-end outstanding volumes being 27% lower than at year-end 2019. Euro-denominated covered bonds account for over half of outstanding volumes (62%), and there have been no euro benchmark covered bond issuances in the country since July 2022.

The substantial decline in housing loan growth since the start of 2022 due to interest rate hikes continued into 2023. Polish banks benefit from an ample and growing customer deposit base, especially household deposits, which is their main funding source. Deposit growth has accelerated since the beginning of 2023, particularly in the household segment. By year-end 2023, the banking sector's loan-to-deposit ratio was 76%, down from 84% the previous year. These factors result in limited funding needs for Polish banks.

We believe that Polish covered bond issuance will remain flat in the near future. Lending for housing began to recover from mid-2023 thanks to the relaxation of the Polish Financial Supervision Authority's recommendation of the interest rate buffer applicable when determining affordability from 5% to 2.5% (only for loans with a periodically fixed interest rate), monetary policy rate cuts and the government's subsidy initiatives, such as the 2% Safe Mortgage Program. In short, this program provides preferential mortgage terms for the purchase or construction of a first apartment or house to certain eligible individuals. The interest rate is 2% for the first 10 years of the loan term, plus a bank margin. However, despite these initiatives, loan growth remained in negative territory throughout 2023, and we expect loan growth to be modest in 2024.

The process of replacing the WIBOR index with a new reference index continues, but in October 2023, the National Working Group for benchmark reform in Poland decided to postpone the deadline for implementing the benchmark reform to the end of 2027. Transitioning to a new benchmark is creating operational and commercial challenges for banks and uncertainties about the effect on existing documentation.

According to the Central Bank of Poland, Polish covered bonds were mostly placed with foreign institutions which as of August 2023 are holding around 62% of outstanding volumes. This suggests that domestic entities' demand for covered bonds is limited. However, issuances denominated in foreign currency involve additional costs, and banks may not find it economical or possible to issue amid the current economic and financial uncertainties if, for example, they are unable to find swap providers or investor demand is reduced.

The first half of 2023 saw discussions regarding the Polish Financial Supervision Authority's proposal for a regulatory requirement aimed at reducing banks' asset-liability maturity mismatch and increasing the share of covered bonds in Polish banks' funding structures. However, we understand that this requirement has not yet materialized, considering, among other reasons, insufficient demand from domestic investors to absorb the supply of covered bonds, which would therefore require stimulating domestic demand first. We expect discussion about this new long-term funding requirement to continue.

Slovakia.   The importance of covered bonds in Slovakia has been increasing in recent years. Despite deteriorating conditions in financial markets, Slovakian issuers remained the most active in CEE in 2023, issuing a total of €3 billion of benchmark covered bonds. This was double the amount of benchmark issuances in 2022 and similar to the strong dynamic in more established covered bond markets.

While earlier borrowings from central bank liquidity schemes have been maturing, potentially adding to some issuers' funding needs, another factor that has supported covered bond issuance in Slovakia is the evolution of loan and deposits. Over the past decade, loan growth in Slovakia has exceeded deposit growth, except during the pandemic. During the post-pandemic years, the difference between these two rates--excess loan book growth--increased due to post-pandemic spending and the subsequent period of high inflation.

Covered bond issuance is historically correlated with excess loan book growth, and Slovakian issuers have turned to covered bonds to fund new lending. This year's first euro benchmark issuance--a €500 million seven-year bond--was issued in March. It was also the first covered bond issued with a seven-year maturity since 2021, in line with the average maturity for Slovakian bonds issued between 2019 and 2021, before interest rate hikes. Slovakian issuances in 2022-2023 tended to have shorter maturities of four years on average, following the general trend for shorter maturities in more established markets.

While loan growth has been trending down since the start of 2023, the recent evolution in deposits is more volatile. While banks' aspirations for further loan growth will also depend on their success in attracting deposits, we believe that covered bonds in Slovakia will remain relevant as a stable source of funding, with moderate issuance volumes for the rest of the year on the back of a slowdown in loan growth.

Asia

Korea and Singapore pioneered covered bond issuance in developed Asia. As local banks' primary funding source is customer deposits, their main motivation in establishing covered bond programs was to manage asset-liability mismatch risk and diversify their funding sources. In 2018, the first covered bond program was set up in Japan. Because there is no dedicated local covered bond legislation, the program was based on a contractual structure.

Despite a surge in liquidity following the COVID-19 pandemic, Asian banks remained active in the covered bond market (see chart 6). This is testament to the strategic importance that covered bonds play in their funding strategies.

Chart 6

We expect that the availability of customer deposits, limited funding needs in foreign currencies, and weak loan growth will continue to constrain issuance in developed Asia. Growth will probably come from new issuers entering existing markets and legislative and regulatory initiatives. We see greater growth potential in developing Asia, where we expect that housing finance needs will grow substantially, but legislative developments will be essential.

South Korea.   Covered bonds can be issued through the Covered Bond Act and the Korea Housing Finance Corp. Act. The Korean Housing Finance Corp. (KHFC) has issued covered bonds since 2010, with Kookmin Bank joining it in 2015. Since then, in 2018, KHFC issued the first social covered bond in Asia and the first Korean euro-denominated covered bond. KEB Hana Bank established its own program and made an inaugural euro-denominated issuance in January 2021.

The Korean Financial Services Commission adopted several measures to encourage covered bond issuance a few years ago, including lower registration fees for bond issuance and lower capital requirements for covered bond investors. These measures incentivized the issuance of South Korean won-denominated bonds, and since 2019, five financial institutions, including KHFC, have issued covered bonds in the domestic market.

We expect Korean issuers to continue using covered bonds, both domestically and internationally, to diversify their funding bases and mitigate asset-liability mismatch risk.

Singapore.   The Monetary Authority of Singapore's Notice 648 established the regulatory framework for the issuance of covered bonds by banks incorporated in Singapore on Dec. 31, 2013, and refined it on June 4, 2015.

With the legislative framework in place, the three major domestic banks have already set up their programs and have together issued the equivalent of more than €16.5 billion as of April 2024. An increase in the asset encumbrance limit to 10% from 4% of an issuer's total assets since October 2020 has provided more headroom for further issuance and will attract new banks to the market. For example, Maybank Singapore Ltd. has recently set up a new covered bond program (see Maybank Singapore Ltd. U.S.$10 Billion Global Covered Bond Programme Assigned Preliminary 'AAA' Rating; Outlook Stable published on March 21, 2024.) However, overall supply will likely be limited because banks in Singapore mostly derive their funding from depositors and have a limited need for foreign-currency funding.

Japan.   Since there is no dedicated legal framework in Japan, when Sumitomo Mitsui Banking Corp. (SMBC) issued the first Japanese covered bond in November 2018, it based its program on a contractual structure. Sumitomo Mitsui Trust Bank launched its inaugural covered bond in October 2020 with a structure similar to SMBC's. Since then, the two banks have issued 11 tranches of public benchmark covered bonds in euros and U.S. dollars, raising a total amount of over €8.0 billion. Given the availability of domestic deposits, it appears that the main reason for establishing covered bond programs is to attract foreign-currency funding.

The Japanese covered bond market could grow considerably. Local lenders are already using collateralized funding, such as residential mortgage-backed securities (RMBS), and they have now started adding covered bonds to the mix. Outstanding mortgage loans amount to about ¥220 trillion, of which only 15%-20% is currently used as collateral for RMBS, leaving ample capacity for covered bond issuance.

Japanese banks have considerable assets denominated in foreign currencies, and covered bonds could constitute a competitive source of funding for these assets. From a risk and regulatory perspective, covered bond issuance can reduce the duration mismatch between assets and liabilities. While the current lack of a dedicated legal or regulatory framework could constrain further issuance, especially for regional players, Japanese banks have been advocating the introduction of a framework to the regulatory authorities.

China.   On May 26, 2022, the National Association of Financial Market Institutional Investors (NAFMII) announced a pilot program for covered bonds. The main goal of the program is to support projects relating to affordable housing and low-rent homes. The NAFMII set out requirements for the registration of covered bond programs, the use of proceeds, and information disclosure. Eligible underlying assets include property and land-use rights, while chattels and intangible assets may also be designated as eligible asset classes in the future.

Compared with auto asset-backed securities and RMBS, domestic covered bonds' transaction structure is more flexible. Asset segregation can occur either through a true sale of assets to a special-purpose entity or a pledge of covered assets. Following the rollout of the guidelines, the first self-labeled domestic covered bond was issued in the interbank market in late June 2022, backed by a hotel's operating income. In our view, there are still legal and structural hurdles to overcome before covered bonds are issued in China in line with international practices.

Interest in dual-recourse issuance among issuers in China increased a few years ago but has appeared subdued in the past year or so.

India.   The country has a significant shortage of affordable housing and a young and growing population. Moreover, household debt as a percentage of GDP is lower than that of other emerging markets. These factors highlight the potential for significant growth in the housing finance sector. Currently, customer deposits are Indian banks' primary source of funding, but issuers and regulators are considering alternative sources of wholesale funding, including covered bonds.

In 2019, for example, the Reserve Bank of India (RBI) established a Committee on the Development of the Housing Finance Securitization Market. This recommended, among other things, an enhanced role for the National Housing Bank and further amendments to reduce transaction costs for securitizations. Like other Commonwealth countries, such as Australia and the U.K., India does not have specific legislation governing securitizations. Rather, the legal framework for India's securitization market is based on existing trust, contract, and property law, and a series of guidelines that the RBI has issued.

From 2019, a number of local entities, mainly nonbank financial institutions, issued self-labeled domestic covered bonds. These bonds replicate some of the structural features of traditional covered bonds--chiefly the dual recourse principle--but don't appear to meet other criteria pertaining to public supervision or asset quality for example. Underlying asset types included gold loans, vehicle loans, and small business and wholesale loans. In September 2021, the RBI issued new asset-transfer guidelines, which, together with further clarifications in December 2022, made it difficult to structure domestic covered bonds in their current form.

While we have not yet seen any international issuance, we anticipate that nondomestic covered bonds may, at least initially, be issued under a general legal framework with an appropriate and supportive regulatory framework. In our view, key clarifications required include whether Indian legislation generally permits the issuance of covered bonds, whether existing securitization guidelines can apply to covered bonds, how to achieve asset segregation, how to treat assets in an issuer insolvency scenario, and whether there are any challenges from a tax perspective, including stamp duty and withholding tax.

Latin America

Covered bonds in this region have a limited track record. Panama was the first country to see a covered bond issuance in October 2012. Since Panama does not have a dedicated legal framework, the covered bonds were based on contractual agreements. Chile has also seen limited and locally distributed covered bond issuance in the past. One factor preventing financial institutions in the region from issuing covered bonds is the lack of a dedicated legal framework. However, things are changing thanks to legislative and market developments in Brazil.

In 2014, Brazil enacted Provisional Measure No. 656, which outlined a framework for Brazilian local covered bonds (letra imobiliária garantida or LIGs). This became Law No. 13,097 in January 2015. Banks only began issuing LIGs in 2018, through private domestic placements. Since 2020, the Brazilian Securities Exchange Commission allowed public placements for LIGs, which further supported domestic issuance. As of January 2024, three banks have more than €21 billion equivalent of bonds outstanding. Issuance peaked in 2022, but slowed down markedly thereafter due to a lack of available eligible assets and regulatory uncertainty (see chart 7).

Chart 7

In February 2024, Brazil's National Monetary Council announced tighter regulation for the issuance of private debt securities linked to financing in the real estate and agribusiness sectors, including LIGs. The new regulation aims at earmarking a share of the proceeds of LIG issuance for the origination of new mortgage loans, but the details are still to be announced. The market is also still waiting for legal and regulatory clarification on how to achieve international issuance. Following such clarification, we believe that Brazilian banks will try to issue LIGs offshore, targeting foreign investors.

Africa

Morocco was the first country in the region to approve dedicated covered bond legislation in 2022. It took almost a decade to approve the final law following the presentation of the draft law, which is testament to the difficulties a legislative process may encounter. Local authorities are still working on the secondary legislation, which we expect them to approve this year. Topics requiring clarification include the possibility of having extendible notes and derivative contracts.

In 2015, South African regulators considered allowing banks to issue covered bonds in the context of a broader discussion about resolution regimes and the introduction of retail depositor guarantees. However, domestic investors remain resistant to the idea of covered bonds due to their concerns about the potential pressure on the pricing of their senior unsecured debt, the losses if an issuer becomes insolvent, and what could happen to the ratings on this debt. As of today, South African banks are still not allowed to issue covered bonds.

Related Research

• Global Covered Bond Insights Q2 2024: Strong Start To The Year For Issuance, March 27, 2024
• Covered Bonds Primer, March 19, 2024
• Covered Bonds Outlook 2024: Stability Amid Turbulence, Dec. 11, 2023
• Central And Eastern Europe Banking 2024: Solid Performance Buffers Mounting Risks, Nov. 21, 2023
• Covered Bonds In New Markets: A Shifting Paradigm, May 24, 2023
• Conflict And Market Conditions Drag On Covered Bond Issuance In New Markets, Sept. 15, 2022
• Covered Bonds In New Markets: Expect Only A Gradual Recovery, March 8, 2021
• How We Rate Japanese Covered Bonds, Sept. 6, 2019
• How We Rate Korean Covered Bonds, May 20, 2019
• New Covered Bond Markets Set To Expand Amid Legislative And Market Developments, March 21, 2019
• S&P Global Ratings Comments On The Czech Republic's Revised Covered Bond Framework, March 5, 2019
• How We Analyze Residential Mortgage Loans Backing Hungarian Covered Bonds, Feb. 20, 2019
• How We Rate Brazilian Covered Bonds, Oct. 16, 2018
• Hungarian Mortgage Covered Bond Framework Allows For Rating Covered Bonds Higher Than The Issuer, Aug. 24, 2018
• Favorable Credit Conditions Underpin Covered Bonds Growth In New Markets, March 23, 2018
• India's Pathway To Establishing A Covered Bond Market, Sept. 12, 2017
• Credit FAQ: How We Rate Covered Bonds In New Markets, Sept. 4, 2017
• A Closer Look At The Brazilian Covered Bond Framework, Dec. 6, 2016
• Could Tighter Credit Conditions Open Up New Covered Bond Markets?, March 4, 2016
• Singapore's Covered Bond Framework Supports Higher Ratings On Covered Bonds Than On The Issuer, Feb. 23, 2016
• New Romanian Law May Support Higher Ratings For Covered Bonds Than On Issuers, Jan. 4, 2016
• Standard & Poor's Comments On Revised Turkish Covered Bond Framework, May 20, 2015
• A First Look At How Poland Might Amend Its Covered Bond Framework, Nov. 13, 2014
• Morocco Looks To Covered Bonds To Support Housing Finance, May 8, 2013