Covered bonds could do with adopting elements of structured finance, according to Standard & Poor’s, which identified the practice as an emerging trend and one that can bring a range of benefits despite the complexity of covered bonds increasing as a result.

“While some covered bond investors see the replication of covered bonds with features of securitisation as a threat to the existing market, we believe structurally enhanced covered bonds can reduce risks that would otherwise be present,” the rating agency said in a report on Monday.

It said that “marrying securitisations with covered bonds” could enhance the benefits of the latter for issuers –  such as relatively low funding costs – and reduce the number of “risk variables” investors are exposed to. Ratings volatility could also fall as a result of an integration of securitisation features, said S&P.

It contextualised such developments by pointing to a desire among policymakers to develop instruments and schemes capable of financing the real economy, which could lead to policy-led government guarantees bringing about new asset types. These could slow the decline of the public sector covered bond market, said S&P, but will require investors to take a fresh look at risk mitigation features in covered bonds, particularly over the long term.

The nature of banks’ public sector loan assets, and consequently their covered bond structures, is likely to change, it said, adding that “already, the distinction between pure public sector and private assets has started to blur”.

As policymakers seek to foster economic growth, public sector entities will increasingly provide more guarantees for loans that banks would otherwise not be willing to grant, said S&P. As cover pools increasingly comprise assets not owned by public sector entities, the need to analyse such structures differently arises, possibly using techniques similar to those applied for structured finance transactions or collateralised debt obligations (CDOs), it said.

In addition, the more public sector guarantees make their way into asset cover pools, the more valuable issuers’ self-imposed restrictions will become to investors, according to S&P.

“We believe investors will likely become more discerning about their choice of covered bond, compared with the traditional approach of trusting issuers to maintain low risk cover pools,” it said. “This can change the way that issuers manage the cover pools.”

It said that some features of master trusts, which can be similar to covered bonds but formally lack recourse to the issuer, could enhance covered bond structures and address bondholders’ vulnerability to changes in the management of a cover pool. For example, master trusts typically carry “stop issuance” or “substitution” triggers linked to the rating on the sponsor, noted S&P.

A pass-through future with contractual OC?

There is a case to be made for structured finance techniques in the context of cashflow structures, too, according to the rating agency. It noted that although the covered bond market generally seems to prefer bullet structures, pass-through structures, typical for structured finance transactions, can help reduce risks and thereby add to the stability of S&P’s covered bond ratings.

“Until recently banks have mostly used pass-through covered bonds for sale and repurchase transactions with central banks,” said the rating agency. “But we believe the issuance of this type of covered bond, and its acceptance by investors, will increase.”

Benefits include lowering default risk and hence the level of overcollateralisation required, which would also entail less balance sheet encumbrance, according to S&P.

“The more bespoke cover assets become and the more widespread the use of covered bonds globally, the more closely investors may examine whether hard bullet repayments are a desired feature under the current definition of a covered bond,” it said.

Contractual commitments to maintain a given overcollateralisation level may also become more widespread, said the rating agency, in response to investor concerns about how to ensure the ongoing buffering of risks in a covered bond to support credit quality.

“We understand, for example, that some investors have been showing interest in features that prevent issuers from reducing overcollateralisation to the legal minimums,” it said, “which could happen if a bank issued additional covered bonds without replenishing the collateral value in the cover pool.”

However, prevailing covered bond spreads do not yet reflect these concerns, according to S&P.

“Covered bonds in countries without contractually committed overcollateralisation, and relatively wide eligibility criteria, currently trade at lower spreads than those issued in countries with contractual frameworks and defined substitution guidelines,” it said. “Interestingly, the documentation for what were previously called ‘structured’ covered bonds, which often trade at higher spreads, include the issuer’s commitment to maintain overcollateralisation at levels that support the initial rating.”