Conditional pass-through covered bonds could benefit more issuers
By Harmen van den Hondel
We expect to see more issuers using this structure in the near future.
CPTCBs enable the orderly sale of assets in a scenario where an issuer becomes distressed, meaning there is no need to sell assets at a high discount or a loss. This in turn means the bond’s credit rating is likely to be more robust, which is better for both issuers and investors.
We expect to see other issuers follow suit as the benefits, and favourable investor reaction, become more apparent.
Traditional covered bonds may be at risk of fire sales of the underlying assets in the case of default. The main difference with a CPTCB is that the underlying assets can only be sold when a loss on the bonds will be avoided. This mitigates refinancing risk in the structure.
Since the CPTCB structure allows an orderly wind-down of the structure, full de-linkage between the Issuer credit rating and the covered bond credit rating can be obtained. As such a downgrade of the Issuer rating does not directly affect the covered bond rating.
As a consequence, the rating agencies also require less underlying assets to be available in the cover pool to protect the bonds, hence in the CPTCB structure much lower over-collateralisation levels can be achieved than in a classic CB structure.
The covered bond market is very conservative, with a well-established product line. As a result this market was the last to close during the credit crunch and subsequently the first to reopen. Many market participants may feel that the current structure therefore works well and there is no need to change it.
However, with the changed ratings environment and increased pressure on credit ratings, there is an impact on covered bonds. Prior to the financial crisis, it could be justly assumed that if there was a default, covered bonds could be sold at a reasonable price. As the crisis made apparent that not all covered bonds were backed by high quality assets, it could now be the case that covered bonds offloaded in a fire sale could be sold at much lower than their expected price.
The only real obstacle to issuers offering CPTCBs is that they may have a large amount of bonds already outstanding. If that is the case, an issuer will need to decide between leaving the existing programme in parallel to a new CPTCB programme or somehow recall or restructure the existing bonds with bondholders’ consent to be converted to the new structure. But when issuing new bonds, we would recommend the pass-through structure.
This option is open to every capital market covered bond issuer, though some may require changes in their documentation. Financial institutions are the most likely to be in a position to take advantage of this structure, and it is less likely – though not impossible – for corporates.
From an investor perspective, it may take slightly longer to get their money back in the event of a default in a pass-through scenario, but ultimately they are more likely to do so, as the bonds are only sold when the price is high enough to avoid a loss. This does mean that it could take up to an additional one to two years to recoup an investor’s money.
From what we have seen when CPTCBs have been issued, investors appear to be very open to new initiatives in the absence of other primary issuance. They see the upside from the structure and understand the benefits.
In 2013 NIBC Bank launched the first-ever residential mortgages CPTCB, with RBS as co-arranger and joint lead manager.
In February 2015, UniCredit became the second issuer ever to issue a CPTCB, again backed by mortgage assets and they were followed in June by Banca Monte dei Paschi, the world’s oldest bank, that converted its existing CB programme into a CPTCB style programme with consent from its bondholders. RBS arranged this transaction.
Since then, we have seen more issuers following suit as the benefits, and favourable investor reaction, become more apparent. Global insurance giant Aegon is the latest Issuer that has publicly released details about its CPTCB programme.
Slowly but steadily the market is adapting and in my opinion it is inevitable that the whole market will eventually change.
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