All material subject to strictly enforced copyright laws. © 2022 Euromoney Institutional Investor PLC group

Pass-through salvation for peripheral covered bonds

Covered bonds will benefit from bank resolution proposals, but rating agencies must see the final wording before implementing new methodologies. By then it may be too late for bonds already on the cusp of a sub-investment grade rating from being downgraded to junk — a move that would prompt forced selling. But salvation is at hand, as Bill Thornhill finds out.

The Bank Recovery and Resolution Directive could cause covered bond issuers plenty of pain before they see its benefits, if rating agencies continue to downgrade their bonds. But a large number of weak issuers in Europe could avoid having their programme downgraded if they were restructured with a conditional pass-through mechanism (CPTM). 

The CPTM covered bond is like any other covered bond, but with one crucial difference — if the issuer is unable to redeem the bond on its maturity date, and the proceeds of a partial sale of the cover pool by the Covered Bond Company (CBC) are not sufficient to redeem the bond, a pass-through mechanism kicks in.

The CBC would only sell assets if the proceeds of the sale were sufficient to redeem the relevant bond without a loss. As long as no successful sale could be initiated, the pass-through mechanism would mean coupon payments on outstanding bonds would continue at the original level on a monthly basis. 

“If you look at the lower level of subordination in ABS compared to over-collateralisation in covered bonds, and take into account the fact that little value is given to dual recourse, it seems like rating agency methodologies are almost forcing issuers to consider pass-through structures,” says Mauricio Noé, head of covered bond origination at Deutsche Bank.   

Investors are, however, concerned that the pass-through mechanism dilutes one key appeal of the covered bond: its bullet maturity. In a pass-through there is a risk of an extension of the maturity and this would jeopardise timely redemption. Moreover, since the pass-through is a key feature of the ABS market, some say it would make a covered bond more like an asset backed security.

But bankers counter that a pass-through creates repayment certainty in stressed conditions. And because documentation on traditional bullet and soft bullet structures is unclear and untested, it is possible that following an issuer’s default, the trustee would have discretion to allow bonds with a bullet maturity to amortise in the same way as a pass-through.          

“When you’re doing something that’s in the legal framework, has regulatory approval and is eligible for low central bank repo haircuts it’s completely wrong to call it an ABS,” says one covered bond banker. 

“What you’re doing with a pass-through covered bond is changing one documentation feature by specifying what happens in the event of an issuer’s default. This structure actually creates greater certainty, post-insolvency, than you have in traditional bullet structures, which have never been properly tested.” 

On top of that, the expected recovery for a pass-through bond is likely to be higher than a bullet or soft bullet maturity.   

“Soft bullet structures encourage a fire sale of the assets when it is unlikely to be a good time to sell,” says Noé. “Investors will get a far higher recovery by allowing the bond to amortise over time, albeit at the cost of extension.”

Sky’s the limit

Standard & Poor’s has said the maximum achievable rating for a pass-through structure is potentially unlimited, although the rating could never exceed the issuer’s sovereign or country rating.   

“Issuers that are up against the sovereign cap cannot avoid being downgraded if their sovereign is downgraded,” says Jennifer Levy at Natixis CB research.  

In other words, if an issuer’s covered bond was rated in line with its government and the government was downgraded, the issuer would also be downgraded, irrespective of whether it had a CPTM or not.

“Pass-through is likely to be a better proposition for weaker issuers in stronger countries as they are less constrained by the sovereign cap,” she says. 

For example, weaker issuers like NIBC which has a senior unsecured rating of BBB- with Standard & Poor’s could potentially get a triple-A rating, in line with the Dutch government. 

On the other hand, the Ba3 rating that Moody’s gives to Portugal means that the highest achievable Portuguese bank covered bond rating would be Baa1. The highest achievable rating in Italy and Spain is Aa2 with Moody’s. 

But the sovereign rating cap is still sufficient to enable weak issuers in weak countries to get an investment grade covered bond rating, which would be considered crucial to avoid forced sales — meaning a CPTM is still definitely worth considering.  

This is particularly pertinent given that the number of covered bond ratings in peripheral Europe that could imminently be downgraded to sub-investment grade or junk may soon double. 

Until now investors have managed to make exceptions to their mandates and re-absorb or sell the covered bonds that have a high yield sub-investment grade rating without destabilising the market. 

“Many investors have so far been able to cope with the rating migration to non-investment grade as this has only affected about 5% of the euro benchmark market,” says Florian Eichert, head of CB research at Crédit Agricole. 

However, a sudden surge in the number of covered bonds facing downgrade would have a much more destabilising impact on the market, he says.

Moody’s has already downgraded many covered bond programmes of individual Spanish banks but the agency has not yet got round to assessing what the impact of individual programme downgrades would be for the ratings of their multi-Cédulas.

Many of the affected banks have issued considerable amounts of multi-Cédulas, which only Moody’s rates. The agency’s actions could impact them all. 

“If Moody’s updates its multi-Cédulas ratings to include the most recent single Cédulas ratings, as much as 10% of the covered market could end up in high yield,” says Eichert. 

“And at that point it will be very hard for investors to get by with exceptions, as the issue will have become much more material.” 

As institutional investors would be unable to continue making exceptions to their mandates on the scale required, they would be forced to sell affected bonds and realise losses. 

This would cause a downward spiral in prices leading to mark-to-market pain for the small pool of remaining investors that are not constrained by the investment grade rating threshold. 

BRRD offers little solace  

Investors had hoped that covered bond ratings would benefit from Europe’s draft Bank Recovery and Resolution Directive (BRRD), which explicitly excludes covered bonds from the bankruptcy estate of the issuing bank. However, any positive rating impact from this incoming regulation may arrive too late to avoid downgrades in the covered bond market. 

Senior unsecured bonds are not excluded from the directive and thus face a much higher probability of being written down in the event of a bank’s failure.  

In early August the Covered Bond Investor Council (CBIC) wrote an open letter to the rating agencies requesting them to revise their rating methodologies. 

Among other things, the council specifically requested that the downgrade of an issuer’s senior unsecured rating should not automatically lead to covered bond downgrades. 

But according to Karlo Fuchs, senior director for covered bond ratings at Standard & Poor’s, it is not possible to change the rating methodology until the precise terms of the Recovery and Resolution Directive have been finalised.

“The way it is currently worded, it appears there is potential for countries to act before bail-in actually happens, so bail-in may hinge on the strength of the sovereign,” he says. “In more healthy countries the sovereign may use that option to avoid bail-in and support the bank, whereas in weaker countries bail-in may become the norm.”

To complicate matters, there are two resolution directive texts written by the European Commission and European Council. The council’s version introduces new features that had not been expected, including requiring shareholders and creditors to absorb losses equal to 8% of total liabilities, including own funds, before structural funds can be used to support a bank. The commission’s version says nothing about this.

This means rating agencies will need to fundamentally reassess the definition of what a bank default actually is before exploring what that might mean for senior unsecured and covered bonds. 

“It will thus take them time to factor bail-ins into their bank rating methodology,” says Florian Eichert, head of covered bond research at Crédit Agricole in London. “Only when they have that in place will they be able to incorporate the covered bond leg of the equation.” 

Bankers believe that rating agencies will begin by reassessing the link between a bank’s issuer default rating (IDR) and its senior unsecured rating. 

When the text of the Recovery and Resolution Directive is finalised rating agencies are likely to come to the conclusion that it is no longer appropriate to assume that taxpayer funds will be used to bail out senior bondholders. 

“Senior bonds are currently rated better than the issuing bank because of implicit government support,” said Richard Kemmish, head of covered bond origination at Credit Suisse. 

“But in future the difference between the issuer’s baseline credit rating [IDR] and its senior rating will probably go down to zero as the probability of governmental support is withdrawn.

“Covered bonds should come out better-rated for two reasons,” says Kemmish. “The first is that all senior bonds act as capital as they are effectively subordinated to covered bonds, and the second is that the directive is effectively differentiating the default of senior notes from the bank that is no longer functioning.” 

But bankers argue that rating agencies should press ahead and delink senior unsecured and covered bond ratings without delay. 

“Although bank resolution rules have not been finalised it’s pretty clear that covered bonds will be excluded from being bailed in,” says Noé. “Though there’s still some uncertainty over voluntary over-collateralisation, which will be difficult to remove, there doesn’t seem to be a good reason to postpone increasing the notching span between a covered bond rating and the issuer’s senior unsecured rating.”

We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree