Issuers like Commerzbank and NIBC have already had some success with SME-backed covered bonds and pass through structures over the last year, breaking away from the market’s raison d’être of rock-solid definitions and legal structures that have traditionally surrounded the product.
The attraction of covered bonds as a brand means issuers are keen to leverage the asset class’s strong reputation in any way they can, by adding bells and whistles like pass-through features or by expanding the range of collateral that can be used to create them.
Commerzbank’s SME-backed structured covered bond, issued in February 2013, prompted consternation from market purists, but it has also sparked interest in such structures.
NIBC’s pass-through feature, used in late 2013, also gathered plaudits — it gives investors recourse to specific pools of assets in the event of an issuer default, matching the amortisation schedule of the bonds more closely with the cashflows from the underlying collateral. This eliminates the need to sell the underlying assets, potentially at steep discounts, to meet payments on the bond.
In February this year, Italy introduced a new form of covered bond backed by assets that were ineligible under the existing OBG framework.
Exposure
And in March, Spain’s government went for the double whammy, proposing a change to the country’s securitization law to allow banks to issue structured covered bonds with conditional pass-through features that minimize the risk of asset fire sales if issuers default.
The law also allows such deals to use riskier collateral than cédulas, including any type of loan, secured or not, to SMEs, as well as corporate loans and bonds.
“This may offer structured covered bond investors less over-collateralisation protection than cédulas and expose them to riskier collateral,” says Moody’s.
ICMA’s Covered Bond Investor Council recently set up a working group — covered bond look alike (Cola) — to discuss new structures in covered bonds and determine whether new products being marketed as covered bonds should be eligible for investors’ covered bond mandates and portfolios.
“Some of the new structures have benefitted the issuers and have received better ratings,” the group wrote. “The Cola working group disagrees with the notion that a covered bond investor should be investing in these new structures only on the basis of a better rating.”
The group unanimously agreed that NIBC’s recent pass-through transaction was a covered bond. However, there was no unanimous vote to include the deal in the relevant covered bond indices.
Metamorphosis
But it is not yet clear how much effect these innovations will have on the definition of covered bonds, says Nathalie Aubry-Stacey, director of market practice and regulatory policy official at ICMA.
“We see these new structures coming out, and we want to make sure investors are able to do their own due diligence,” she says. “Investors have a certain view of covered bonds and we need to see whether this traditional view fits with the new products.”
Aubry-Stacey says these new structures are a logical market development, given the political pressure being applied to banks to invest in the real economy.
“These new deals are inspired by the covered bond structure. It’s all about how issuers are trying to get better ratings,” she says. “Whether it will push the definition of what is a covered bond depends on how many deals of this type we see.”
Once a covered bond starts amortising on a pass-through basis, Cola says it would probably be removed from the relevant indices, as they are made up of fixed rate bullet bonds.
The NIBC structure also means that principal could be repaid before the original maturity date because of the random asset selection process embedded in the programme if the amortisation tests are breached.
The delinked rating approach to pass-through bonds states that bonds may continue to be investment grade even after the issuer has become insolvent, but will not follow their original payment schedules.
“Mandates in need of a fixed cash flow structure or with restrictions regarding the maximum allowed maturity of individual bonds in a portfolio [may] refrain from buying these structures in order to fully comply with their guidelines,” says Cola.
Brand recognition
Jennifer Levy, a covered bonds and agencies analyst at Natixis, echoes ICMA’s concerns about investor education on new products.
“It creates a riskier covered bond,” she says. “Pass-through structured covered bonds in Spain will be allowed to have riskier collateral. Compared to cédulas it is not as safe, because for cédulas you have recourse to the whole mortgage portfolio, whereas for SCBs you only have access to specific cover pools and an unsecured claim against the issuer’s balance sheet.”
Once again, covered bond purists might be forgiven for feeling that such structures sully the watertight definition of covered bonds, essentially using the brand to market a different product.
“In Spain, it is a securitization law [that now permits these bonds], but [the product] could be called a structured covered bond,” says Levy. “It could be misleading.”
Ratings boost
Pass-through bonds also benefit from a delinked ratings methodology — S&P does not take the issuer’s senior unsecured rating into account when rating the bonds, while Moody’s delinks the rating to a large extent but not completely.
Issuers with high unsecured ratings will have less incentive to print pass-through bonds than those chasing higher ratings, says Bernd Volk, head of covered bond research at Deutsche Bank.
“The perceived stronger market access via covered bonds contrasts with the fact that many issuers started with issuing unsecured bonds instead of covered bonds recently,” he says.
He points out plenty of other factors that might make issuers think twice about choosing the pass-through mechanism.
“Also, bank resolution will likely not be considered a ‘default’ regarding pass-through covered bonds — so the covered bonds will still need to be paid and cannot be extended simply due to the fact that a bank resolution was started,” he says. “And in the case of covered bonds issued by a specialised bank like in Norway or Ireland, it will be costly to set up a separate issuance entity to issue pass-through covered bonds.”
Have yield, will travel
Given how desperate investors are for yield, pass-through covered bonds will be an attractive option for plenty of investors despite the increased risk and potentially unpredictable payout schedule, says Levy at Natixis.
“Because of the search for yield, pass-through covered bonds could find some appetite, because they offer a premium over the secondary market and peers,” she says.
NIBC’s pass-through covered bond was priced with a 5bp-10bp premium over the issuer’s existing non-pass-through covered bond curve, she points out. “This could inspire appetite but it might not be the best product for traditional covered bond investors.”
But pass-through structures are eligible for level 2A of the liquidity coverage ratio, so banks will be able to buy them without qualms — another advantage of the structure.
That is not the case for SME-backed structures. Traditional German covered bond investors were big players in Commerzbank’s SME covered bond, taking 44% of the deal. In terms of investor type, the deal had a fairly even distribution, with central banks buying 26%, fund managers 28%, banks 27%, insurance 6% and others 3%.
But Levy reckons asset managers will be the main buyers of SME covered bonds because they are not eligible for the liquidity coverage ratio, meaning there is a disincentive for banks to hold them as an investment.
The rash of new structures may be bewildering for covered bond purists, but issuers are always going to try to find ways either to expand the definition of covered bonds, or tweak the existing products to achieve better ratings.
The key to deciding what flies and what dies is avoiding structures that simply repeat the mistakes of the sub-prime RMBS crisis, where poor quality collateral can be repackaged in a certain way and masquerade as a new product with a triple-A rating.
ICMA’s Cola working group will continue to assess new covered bond structures as they come, and it will be thorough. But for the moment, it is up to investors themselves to do their due diligence, and do it well. But in today’s yield-crazed market, the question is whether they will have the patience to do that.