Challenges posed by the inclusion of conditional pass-through (CPT) covered bonds in indices, rating methodology “weaknesses” and the potential for an “sf” rating suffix are among points raised in a comment by an ICMA CBIC working group on CPT issuance by NIBC.

Dutch issuer NIBC Bank broke new ground in the covered bond market last year when it sold the first benchmark legislative partial pass-through covered bond, a Eu500m five year mortgage backed-deal, and a working group of the ICMA Covered Bond Investor Council (CBIC) on Tuesday presented its comments and findings on the CPT programme. (The full comment can be found here.)

The working group was created in the autumn of 2013 in response to the rise of non-traditional covered bond structures and to help investors decide how to treat “covered bond look-alikes” (hence the group acronym and moniker “Cola”). It is chaired by Ralf Burmeister, senior portfolio manager for covered bonds at Deutsche Asset & Wealth Management.

“The aim of the working group is to increase the understanding of the nature of the specific innovation and to put it into context within already established structures and/or legislation,” it said on Tuesday upon release of the comment.

The working group addressed various cashflow characteristics of the CPT covered bond, looking at aspects such as early repayment and extension risk. It said that it has unanimously concluded that NIBC’s CPT issue is a covered bond and that there is a consensus – but no unanimity – to include the CPT bond in the relevant covered bond indices.

The working group also raised the question of whether, “for the sake of transparency”, covered bond programmes featuring “non-standard cashflow procedures post-insolvency” could be labelled with the rating suffix ‘sf’, for structured finance.

It flagged this “just as a point for future discussion” and said that this was a question that emerged during the working group’s discussions about CPT covered bonds.

Drilling deeper into the detail of the CPT structure, the working group said that certain cashflow characteristics “cause some concern and possibly asymmetries” when such a covered bond is included in the prevailing investment universe as defined by relevant covered bond indices.

“[O]ccasions may occur where mandates in need of a fixed cashflow structure or with restrictions regarding the maximum allowed maturity of individual bonds in a portfolio refrain from buying these structures in order to fully comply with their guidelines also in a strict interpretation, i.e. despite the fact that the bonds are hard bullet maturities as long as the issuer is solvent,” said the CBIC working group. “If conditional pass-through/pass-through were to gain further weight in the relevant indices, this could create a relevant deviation between the investible universe of bonds and the benchmark the portfolio is measured against.”

They noted that in their understanding, once a covered bond were to start amortising on a pass-through basis it would probably not remain in the bond indices as these comprise fixed rate bullet bonds, even though payments may still be made to investors on the basis of the originally agreed coupon.

Another of the many detailed points made by the working group concerns the way in which NIBC’s CPT covered bonds has “again brought light to a weakness in the rating agencies’ methodology from the investor’s perspective – for good or for bad”, with this weakness being how a default is defined.

The investor group said that rating agencies’ analysis of potential delays in the contractually agreed payment schedule does not take net present value (NPV) calculations into consideration, but that these are relevant for investors.

“Several sell-side analysts pointed out that extension risk (as well as early repayment risk … ) is not included in a credit rating from rating agencies,” said the working group. “In the view of the majority of the Cola working group, a default is clearly a failure to redeem at a scheduled maturity instead of not fully redeeming the bond at the legal maturity date.

“The structure thus places emphasis on the protection of the principal repayment, and not necessarily on the net asset value (NAV) of the investment. In the light of accounting standards, the appeal of this mechanism will be viewed differently by the various types of investors.”

Officials at NIBC told The Covered Bond Report that they welcome the investor council’s comment and the attention that is being paid to the issuer’s conditional pass-through covered bonds.

“We’re happy to have these types of discussions and to have investors engaging with the product and the structure,” said Niek Allon, treasury at NIBC Bank.

However, he and his colleagues believe that many of the comments made by the investor body about certain aspects of the conditional pass-through structure are also applicable to the traditional covered bond structures.

“The piece makes a comparison between hard bullet and conditional pass-through covered bonds, but many of the things raised, including some of the critical points, are also embedded in hard bullet and/or soft bullet structures,” said Allon.

Thomas Van Steenbergen, vice president, structuring at NIBC, noted that the CBIC’s comment provided a very in-depth analysis of the conditional pass-through structure and in doing so also of the covered bond product, and that this is an important by-product of NIBC’s issuance of CPT covered bonds.

“By writing down the procedure for liquidating the underlying assets in the event of an issuer default and the pool not providing sufficient funds, the market also has to think about how this works in the traditional structures,” he said. “Because we put this roadmap in our documentation it has sparked a bigger discussion about covered bonds, and not just conditional pass-throughs.

“But many of the points mentioned are also applicable to soft and/or hard bullets.”