Moody's: Refinancing risk lessens materially in conditional pass-through covered bonds

More covered bond issuers have been structuring their covered bond programme platforms as conditional pass-through covered bond (CPTCB) transactions to benefit from the much lower refinancing risks and time subordination between series that CPTCBs can provide. However, the type of structure that the issuer decides to use will determine whether the programmes can effectively mitigate refinancing risk, says Moody's Investors Service.

"Issuers have made use of CPTCBs to lessen, and in such cases remove significantly, the element of refinancing risk that is characteristic of almost all covered bond deals" explains Jose De Leon, a Moody's Senior Vice President - Senior Analyst. "There is also a drive to optimise the level of over-collateralisation levels they commit, so that the removal of refinancing risk can in some cases make the CPTCBs much less dependent on, or, even independent of, the supporting bank's credit strength."

Moody's says that CPTCBs have maturities that typically extend for the life of the assets if the issuer ceases making payments under the covered bonds and there are insufficient funds to meet the timely principal payments on those bonds that have reached maturity. The pass-through mechanism is then typically activated for the affected series that become a pass-through series, while the remainder would repay at their scheduled maturity if sufficient funds are available -- otherwise they would also switch to pass-through.

"However, despite their benefits, not all conditional pass-through structures provide the same level of mitigation against refinancing risk and time subordination between series, and the type of structure the issuer decides to use will be influential," says Mr. De Leon.

"For example, the level of OC that the issuer commits when the deal is launched is key. Refinancing risk and thus a fire-sale of the cover pool may materialise in a CPTCB programme if the level of OC in a transaction is insufficient to cover potential credit losses from the underlying borrowers. Furthermore, even in CPTCBs, a fire-sale of the cover pool at high discount rates might occur in some transactions, as the breach of certain tests may lead to an event of default under the notes," explains Mr. De Leon.

Provisions that can reduce time subordination amongst series may include, among others:

--- The issuer commits some level of OC to protect the credit losses in the pool; the collections used to repay the CPTCBs thus do not erode the OC available for the remaining series.

--- The breach of the amortisation test makes all series become pass-through.

Time subordination occurs when the first maturing series take advantage of the assets' collections and possibly a more-than-proportionate share of the OC in the pool, in case of partial sale for their redemption.

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