NIBC Bank is exploring setting up a partial pass-through covered bond programme for issuance to end investors and has been doing some preparatory “fact-finding work”, although no deal will be announced any time soon, an official at the bank told The Covered Bond Report.

The issuer’s plans were mentioned in Commerzbank research dated yesterday (Tuesday), which noted that NIBC in December gathered investor feedback on plans to introduce a programme for pass-through covered bonds, and were confirmed by the NIBC treasury official.

“NIBC has indeed been doing some fact finding work for a new – pass-through – covered bond programme,” said the NIBC banker. “A pass-through covered bond allows for higher and more stable ratings which better reflect the underlying strength of our programme and collateral.

“This would be beneficial both for investors as well as the issuer.”

The issuer has been collecting some useful investor feedback as input to its structuring process, he said, which is very much in the early stages.

“So do not expect a programme or transaction announcement any time soon,” he added.

With the notable exception of Danish-style covered bonds, pass-through covered bonds have hitherto been used by issuers for repo with central banks but not sold publicly to end investors, so NIBC’s plans – should they result in issuance of pass-through covered bonds in the open market – have some market participants excited about the broader implications for the asset class.

“We consider this a very interesting project, because if it succeeds it could send out a signal to other issuers and therefore in the long term change the face of the entire market,” said Commerzbank head of covered bond research Ted Packmohr. “Various banks could be keen in principle to establish pass-through covered bonds in the market as a third maturity type alongside the existing hard and soft bullets.”

According to Packmohr, NIBC is exploring two possible pass-through models. One would involve all covered bonds being converted to pass-through immediately in the event of an issuer bankruptcy, and thereby being serviced equally. Under another structure, after an issuer bankruptcy, the covered bonds could be converted to pass-through gradually when they reach their respective maturity dates, which would avoid early redemption and preserve the structural subordination of longer maturities.

“We think that many investors would prefer the second variant, given its greater similarity with the current covered bond model,” said Packmohr.

According to NIBC, he added, the Dutch central bank has already signalled that it will accept pass-through covered bonds, which would mean that that they would be Ucits and CRD-compliant.

As referred to by the NIBC treasury official, a key attraction of partial pass-through covered bonds for issuers is the prospect of achieving higher ratings. This is because a pass-through structure eliminates the need for a disadvantageous fire-sale of cover pool assets that might arise in the event of an issuer default under a hard or soft bullet structure, and eliminates refinancing risk.

This, said Packmohr, would lead to higher and more stable covered bond ratings, together with lower liquidity costs and overcollateralisation requirements.

For example, a new SME backed structured covered bond programme set up by Commerzbank – and scheduled for a roadshow next week – incorporates a partial pass-through mechanism that Fitch said was the major driver behind its assumption of minimal discontinuity risk, and the awarding of a Discontinuity Cap of 8, although Packmohr noted this on its own did not guarantee a triple-A rating (Commerzbank’s programme has provisional ratings of AA and Aa2 from Fitch and Moody’s, respectively).

Another covered bond analyst noted that pass-through structures would reduce rating downgrade pressure and make the covered bond business model more economical. He said that the pressure to introduce such structures is limited as long as central banks prevent bank insolvency by providing liquidity, even though central banks would “probably welcome” pass-through covered bonds because they would transform refinancing risk for central banks to extension risk for investors.

Some traditional covered bond investors have typically been critical of the pass-through structure, and one investor told The Covered Bond Report that he is skeptical about developments that diverge from traditional covered bonds, at least with respect to how new covered bond products such as pass-throughs or SME backed issuance would appeal to the traditional European investor base. It was already not straightforward to be allowed to invest in soft bullets, he said.

Commerzbank’s Packmohr said that attempts to establish pass-through covered bonds among investors are not surprising given a strong downward rating migration in the covered bond market.

A triple-A rating achieved with the help of a pass-through structure should not be expected to be valued the same by investors as a top rating based on a traditional structure, he said, but pass-through covered bonds could “provide a way of keeping rating-sensitive investors interested, ensuring that regulatory rating barriers are observed and thus stabilising demand for bonds of lower-rated issuers”.

Another analyst said that although he would normally be cautious about the market potential for pass-through structures, “we would not have thought that peripheral banks price senior unsecured bonds tighter than respective sovereign bonds either”.

And in a Fitch survey conducted as long ago as December 2010, 52.5% of investors polled said that they would consider purchasing either partial or pass-through covered bonds.