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Let's hear it for pass-through covered bonds

15 Jan 2013

A covered bond that offers identical credit quality to any other but which is immune from rating volatility should prove a boon to both investors and issuers. A pass-through structure would achieve just that, and NIBC’s decision to explore it should be applauded.

Whether they like it or not, covered bond investors are bound by ratings. They are part of regulatory DNA and are integral to the eligibility criteria of those covered bond indices that many passive funds are obliged to shadow.

But almost any sophisticated covered bond investor will tell you that the low ratings of many deals do not correspond to the buyside's view of their high quality.

Portugal's Caixa Geral de Depósitos — a systemically important bank and unlikely to fail — issued a covered bond this week. It is backed by 259,600 first lien residential mortgage loans to borrowers that have been successfully servicing their debt for nearly eight years, and where the average loan to value is just 53.8%.

That would already suggest high quality. But even though the borrower is committed to backing deals by 35% more collateral than debt, it still only gets a Baa3/BBB- rating. One further notch of rating downgrade and many holders would be forced to sell their investment.

This is crazy.

The largest source of rating uncertainty relates not the collateral but to the market risk. Market risk reflects the agencies’ uncertainty that, when the time comes to repay noteholders and redeem bonds, the issuer will not have the necessary wherewithal on the date the bonds mature.

This is because the bonds have a bullet maturity, which means the borrower’s liability structure spikes up every time a deal redeems. On the other hand, the cash flows coming off the pool of mortgage assets are steady and slow to move.

In other words, the cash flow does not mirror the flow of payments to investors.

There is a way to avoid this. By structuring a legally compliant covered bond with a pass-through that would only be activated when the issuer becomes insolvent, this potential source of payment disruption would be nullified.

Bond redemptions would be paid purely from the collateral pool and there would be no obligation on the cover pool administrator to meet bullet redemptions through the forced sale of assets.

The risk to investors is that they may not get paid on time — but they are more likely to be repaid in full. As things currently stand, a forced sale of assets could deplete the cover pool to such an extent that some investors of longer dated securities would never get their money back.

There are two other big advantages. The first is improved efficiency, because of the much lower overcollateralisation that would be needed with a pass-through covered bond. The second, resulting from the first, would be a handy bolstering of supply.

It's not often that a development gets mooted where the effects are such a happy double-whammy. The market should be thankful.

15 Jan 2013