Conditional pass-through covered bonds are likely to become more popular with issuers – initially among Dutch banks beyond NIBC – and certain investors, and could enable covered bond refinancing for non-traditional collateral such as SME loans, S&P said yesterday (Monday).

NIBC Bank sold the first ever partial pass-through legislative benchmark covered bond on 1 October, backed by traditional collateral in the form of mortgage loans, and Standard & Poor’s welcomed this as a positive development for the covered bond market.

The rating agency identified several benefits of a pass-through structure, such as lower overcollateralisation and therefore asset encumbrance, higher ratings and reduced rating volatility. But it acknowledged that a conditional pass-through (CPT) covered bond such as that pioneered by NIBC brings with it extension risk.

However, S&P said that NIBC’s recent deal suggests “a significant number” of traditional investors are already willing to buy CPT covered bonds and that even if the structure will not suit all investors it is likely to gradually become more popular.

“We anticipate that the bonds will be attractive for some issuers — particularly smaller lenders whose ICR [Issuer Credit Rating] may constrain the rating on their covered bonds, and those with programmes with no established secondary market for the assets,” said Nicolas Malaterre, credit analyst at S&P.

“This might be the case, for example, with emerging market programmes, or where the programme features non-traditional collateral (for instance, loans to small and mid-size enterprises).”

Dutch issuers beyond NIBC could lead a wider take-up of CPTs, according to S&P, given that a high prevalence of interest-only loans in the Netherlands contributes to comparatively high asset-liability mismatch (ALMM) risk and consequently high target overcollateralisation. CPT issuance could therefore allow small to mid-sized Dutch banks to conserve collateral and achieve higher ratings on their programmes compared with traditional bullet structures while potentially diversifying their investor base, said the rating agency.

CPT issuance could be attractive for lower rated issuers in other European countries for similar reasons, said S&P, noting that target overcollateralisation levels are high in the UK and southern European jurisdictions relative to elsewhere in Europe.

“Issuers of programmes with no established secondary market for the assets also stand to reduce target credit enhancement levels from CPT structures,” said the rating agency. “This might be the case, for example, with emerging market programmes, or where the programme features non-traditional collateral (for instance, loans to small and mid-size enterprises).

“Finally, we note the increasing regulatory focus on asset encumbrance, which could push issuers to further reduce the proportion of their assets that they use to collateralise debt issuance.”