Covered bonds have been evolving in the last few years, with new jurisdictions, new collateral formats, and different laws. But the most popular twist on the conventional covered bond formula is the "conditional pass through". These bonds feature a trigger than extends their maturity when the covered bond issuer defaults. It's not a small extension, either — the aim is that the mortgages backing the covered bond will be able to pay down over time, rather than being sold at fire sale prices.
That means the bonds can achieve higher ratings, which are less connected to the rating of the issuer, and need small cushions of extra collateral to protect the bonds.
But they haven't been universally popular. The risk of a maturity extension in conditional pass through (CPT) covered bonds is something established covered bond investors would rather avoid.
But they could be better off buying these structures than long dated soft or hard bullet bonds, where they could, in effect, be subordinated to other bondholders by the long dated of their issues.
If a covered bond issuer cannot pay its covered bond, the cover pool becomes the sole source of payments, and bonds would be paid based on their scheduled maturity.
But a forced sale of assets in a systemically dysfunctional market — if a substantial European bank has gone down, the market will already be severely damaged — would have to be executed at a heavily discounted price.
This would quickly deplete the cover pool, with a meaningful risk that there would be insufficient collateral to redeem bonds which mature later. This leaves long dated bonds subordinated to short bonds, with a materially higher risk of loss.
These concerns were highlighted by Fitch this week in a peer review it published on the Portuguese covered bond market.
The rating agency said that Portugal’s legal covered bond framework allowed for a cross acceleration of all outstanding bonds provided two thirds of noteholders agree. But since the senior position of short dated note holders would be weakened by agreeing to accelerate, it would not necessarily be in their interests to agree to such changes.
Time subordination is not an issue that is specific to Portugal, it is also a problem Fitch has identified with the French legal framework. But it is more acute in Portugal, as the programmes are, in theory, more likely to default than those in France.
Borrowers can easily resolve this problem by restructuring their programmes to conditional CPTs.
This is because, under the CPT structure, all maturing bonds would automatically rank pari passu following a switch to pass through payments. That means all bondholders, irrespective of maturity, could be certain of receiving coupon payments until all bonds were redeemed in full.
This equal treatment was highlighted in another report published this week by Moody’s. The agency said lower rated issuers should be more incentivised to issue CPTs because the higher ratings these bonds can achieve attract a lower repo haircut with the European Central Bank.
On Monday the ECB implemented tighter repo rules, where the valuation haircut for bonds rated below A3 is 12% compared to 8% for bonds rated A3 and higher. It closed an exemption which meant that issuers posting less than 75% of an issue as collateral did not need to use the higher haircuts.
Moody’s identified 13 covered bond programmes rated lower than A3, including five from Portugal, two from Italy and two from Spain.
The agency said CPT structures are “of higher credit quality” than typical covered bond structures as they allow the orderly wind down of the cover pool “without any requirement to sell or refinance cover pool assets at a high discount that could exacerbate losses to covered bondholders.”
Established covered bond investors may not like the extension risk inherent in CPT structures but they do at least provide certainty following an issuer’s default. And in light of the resolution fiascos surrounding Komunalkredit and Novo Banco, certainty is at a premium, and the CPT structure merits more attention from all sides of the market.