The advantages to the issuer of a conditional pass-through structure that Dutch bank NIBC could debut in the coming days are clear, but ahead of the ground-breaking transaction investors and analysts ask: What’s in it for the buy-side?

The issuer started a roadshow last Monday (16 September) and is due to wrap up meetings tomorrow (Tuesday). Credit Suisse, LBBW and RBS were mandated for the roadshow alongside NIBC’s investment bank, with a deal expected to follow afterwards.

The motivation for issuers to go the way of NIBC is ultimately seen as the achievement of higher ratings at lower overcollateralisation levels than those required for the same rating level on a hard or soft bullet covered bond.

NIBC’s conditional pass-through (CPT) programme, as the issuer is describing it, is being rated triple-A by Fitch and Standard & Poor’s, versus an A+ rating from Fitch for the Dutch bank’s soft bullet programme.

“The AAA is quite impressive,” said UniCredit analysts, “given NIBC’s low senior rating of BBB-, which is the starting point for deriving the covered bond rating.”

Key to how a partial pass-through programme achieves this is the avoidance of a potential fire-sale of cover pool assets in the event of an issuer default.

RBS analysts said that various forms of pass-through covered bonds are under discussion, and that they have in common the aim of allowing an orderly sale of the underlying assets in case of issuer default.

“This is achieved by transferring the mismatch risk between the maturity of the underlying assets and the maturity of the bonds to the investors,” they said. “The removal of the fire-sale risk enables the CPT covered bonds to achieve higher ratings than conventional covered bonds and better rating stability as the rating agencies grant them a higher rating uplift over the issuers’ unsecured rating.”

An official at NIBC noted back in January, when it was discussing the idea with investors, that this is not just beneficial to the issuer.

“A pass-through covered bond allows for higher and more stable ratings which better reflect the underlying strength of our programme and collateral,” he said. “This would be beneficial both for investors and issuers.”

Analysts have also identified higher and more stable ratings as being an advantage for the buy-side, and this point was corroborated by an investor at a European Covered Bond Council plenary in Barcelona on 11 September.

Asked for his views on NIBC’s plans, Henrik Stille, portfolio manager at Nordea Investment Management, said that he will “definitely” consider pass-through structures and that these offer a source of greater rating stability. He was encouraging of a wider take-up of the repayment profile, especially by lower rated issuers.

Another benefit for investors, according to Joost Beaumont, fixed income strategist at ABN Amro, is a high recovery rate in the event of an issuer default.

“According to the conditional pass-through structure, the cover pool will even only be sold if proceeds are sufficient to fully repay investors,” he said. “In a hard bullet structure, it seems likely that investors need to accept a loss on their investment in a worst-case scenario, reflecting that the covered bond company must likely sell the pool at distressed prices.”

The amount of time that will probably pass before the cover pool can be sold at a price sufficient to redeem all bonds seems manageable, he added, given the overcollateralisation ratio increases proportionally.

Conversely, the greater extension risk the conditional pass-through structure confers upon investors has been highlighted – while one investor noted that there is also a risk of prepayment.

“You’re getting a better rating at a presumably higher spread at the cost of greater variability of payment flows in the event of an issuer default,” he said. “With a hard bullet covered bond there are far fewer options in such a situation.”

He also said that it is important for investors to ask themselves just what the ratings really reflect, and another investor said that the much higher rating achievable through the CPT structure is not comparable with other covered bond ratings.

“The CPT covered bond structure is an indefinitely soft bullet and not a pick-up in credit quality,” he said. “The much higher rating simply reflects cashflow netting after the insolvency of the issuer.

“Investors should have a look at the issuer rating of the covered bond rating based on a probability of default, if provided.”

UniCredit analysts argue that casting the trade-off as one of a higher probability of repayment versus uncertainty about the timing thereof is misleading, however, at least when pass-through structures are compared with bullet covered bonds that do not feature a liquidity buffer.

“An aspect that weighs negatively on this, however, is the implicit assumption that an investor is accepting a higher nominal recovery at the expense of a longer time to recovery,” they said. “In fact, from a net present value perspective, a quicker sale of assets might have a higher net present value.”

Furthermore, when it comes to bullet covered bonds with a liquidity buffer, as is mandatory under most modern covered bond legislation, they said, in the event of an issuer default the switch to pass-through is much more likely than a default of a bullet covered bond.

“Translated into expected duration, this means that the expected duration of a pass-through covered bond is higher than the expected duration of one with a bullet payment promise,” they said.

They suggested that fire-sales post-issuer default are an overstated consideration when it comes to weighing up the pros and cons of pass-through covered bonds versus conventional issuance, and that this can lead to some of the positives of the NIBC structure being exaggerated.

“Many market participants tend to think that the most important way to do ALM in a post-issuer default world is selling cover assets for funding reasons,” they said. “This could be tough in a distressed market environment.”

Feedback from investors contacted by The Covered Bond Report was varied, with some having engaged with it quite intensively, some yet to make their minds up about the structure, and others saying the bank and programme were too small to be of interest.

At least one was clearly unconvinced by arguments that benefits were balanced between investors and issuers, saying that the structure was “made up from an issuer point of view, but investors’ needs are not so much taken into account at all, I would say”.

A portfolio manager who said he was “fully on top” of the structure was nevertheless unsure whether his investment house would participate in a transaction, saying that this would depend on the yield that can be achieved.

“There is no market for pass-through covered bonds in euros so we are more eager to see the outcome given that we are not sure of the demand for the product,” he said.

Another investor said he assumed an offering from NIBC would come with a pick-up versus its traditional programme, and versus standard covered bonds from issuers such as ABN Amro and ING given that the latter have been designated systemically important banks but not NIBC.

Pia Maalej, senior covered bond analyst at BayernLB, touched on this, saying that the issuer rating will be an important factor for the pricing of NIBC’s deal, and that this would ultimately be reflected in a pick-up. A novelty premium will also presumably be required, she said, and the investor said that the spread should incorporate some compensation for the effort required to get to grips with a structure of considerable complexity, adding that this a “crude” but fair request.

One of the other investors echoed this, saying that the analysis necessary clearly has more ABS-like components than traditional covered bonds do.

“Therefore investors are asking for a higher spread in return – closer to RMBS than covered bonds,” he said.

Market participants generally expect an inaugural deal to be priced to sell.

However, a covered bond banker said that in the long run a pass-through covered bond such as the one targeted by NIBC should not have to pay up versus traditional covered bonds, and that there is a good argument for it to come at a tighter spread.

“Do you want a traditional extension (less cash, sooner in default)? A pass-through extension (more cash, later)? Or a ‘not documented’ structure (up to the trustee)?” he asked. “I’m guessing that you will see some good performance in secondary.”

RBS analysts said that conditional pass-through covered bonds should be interesting for ordinary covered bond investors, especially if issuers offer a spread pick-up for the additional risks involved. At the same time, however, they cited probability of default statistics of a single-A rated issuer to argue that there is a high chance – 99% – that the repayment profile of a five year conventional covered bond and that of a conditional pass-through issue will be the same.

They also said that in the less than 1% chance that the cashflows will be different, this does not mean that they will be lower in the case of a pass-through covered bond.

“[T]here are scenarios where the repayment profile of a pass-through covered bond is expected to be higher than that of a hard bullet or soft bullet covered bond,” they said.