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FIGCovered Bonds

Time for a consistent conditional pass through

Part of the selling point of covered bonds is that they are a relatively easy to understand, safe investment. But this has become less true over time, especially in conditional pass through structures. It's time for a more unified approach.

As part of the drive towards covered bond harmonisation, the European Banking Authority, European Parliament and European Commission are likely to put in place recommendations that set out the conditions for a maturity extension of a conditional pass through covered bonds sometime early next year.

Regulatory recognition will probably only be granted to those covered bonds where the extension is not be triggered at the discretion of the issuer. 

But it is also possible that the European authorities will set out principles that enshrine the most investor friendly CPT structures.

Dutch CPTs, for example, can only extend following an issuer default and the failure of the asset coverage test. If the bond switches to pass through, there is an obligation to conduct an asset test every six months to see whether a part of the portfolio can be sold at a sufficient price to repay the first maturing noteholder without having a detrimental impact on other creditors.

In contrast, CPT structures used by Caixa Economica Montepio Geral and Novo Banco can be extended before the issuer defaults if there has been a breach of the legal minimum overcollateralization ratio.

These Portuguese transactions were always designed to be retained by the issuer for the purpose of accessing the European Central Bank’s repo facility — so the issuers had no need to add the investor friendly features needed to place deals in the market.

But apart from different trigger conditions, there are other features which make the burgeoning CPT market harder to understand.

When Dutch CPT deals breach their amortisation test, all outstanding bonds switch to pass through. On the other hand, under UniCredit’s CPT structure, a breach of the amortisation test leads to a cross default and acceleration of all outstanding bonds.

And when it comes to time subordination, the Italian deal offered by UniCredit differs markedly from another issued by Monte dei Paschi di Siena, while both differ from the Dutch and Portuguese deals.

The new deal from Bank of Queensland (BoQ) this week muddies the waters still further. Though it works similarly to the Dutch deals and is designed to be placed into the market, the pay down is nuanced.

Following an event of default the earliest maturing bond will start to amortise and the bonds could be fully repaid even if the maturity date has not been reached. When the nearest maturing bond is repaid, then it is possible that the next maturing bond could also be repaid early.

The premature acceleration trigger has led some participants to question whether noteholders of the prospective BoQ deal might lose economic value. This could potentially occur in a scenario where the coupon is high but the rates environment is low. In such circumstances the bond price would be expected to be well above par.

Such considerations are probably not a great concern in the securitization market where bonds are predominantly floating rate. But they could be interpreted differently in the predominantly fixed rate covered bond market.  

This difference is unlikely to scupper the new deal — indeed, it could be seen as investor friendly — but the little differences between the various CPT structures do add up. And the more different variants CPT covered bonds come in, the less likely it is that European Commission plays nice when it presents its draft covered bond framework.

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