The development of a conditional pass-through (CPT) structure shows an increasing overlap between covered bonds and RMBS, but investors demand a premium for a CPT issue, DBRS said yesterday (Wednesday). A strategist suggested the latter is not necessarily the case, however.

The rating agency said that residential mortgage-backed securities (RMBS) continue to be predominantly amortising floating rate instruments, but that the covered bond product is changing, with “exacerbated refinancing risk embedded in bullet covered bond structures” leading to the development of CPT covered bonds.

CPT covered bonds were pioneered by Dutch bank NIBC, which in October sold its first issue off a CPT covered bond programme and will next week be roadshowing in connection with a potential second deal. Commerzbank has also sold a partial pass-through covered bond, but this was not backed by traditional collateral as is the case with NIBC’s mortgage-backed deal, and the German bank’s deal, given SME loans serving as collateral, was also issued outside of a dedicated covered bond legal framework.

The credit crisis was a turning point for the way in which market participants think about the covered bond product, according to DBRS, with the default of an issuer/sponsor having been considered a remote event before then and covered bond investors generally expecting they would have been made whole by the regulator or sovereign.

However, the credit crisis has “put the covered bond afterlife in the spotlight”, it said.

“Market participants have increasingly questioned how it would have been possible to bridge liquidity gaps and meet bullet maturities in an environment where sovereign strengths were challenged, credit profiles of issuers were worsening and funding was becoming increasingly expensive and scarce,” said DBRS.

Covered bonds have increasingly transformed from being a rates product to a credit product “and a more expensive product for sponsors to maintain”, said DBRS, noting that increased awareness of the reliance of timely payment of covered bonds on issuer/sponsor creditworthiness has led to higher overcollateralisation (OC) requirements.

The rating agency noted that traditional covered bond investors “may be embracing the possibility of an extension risk” involved in a CPT structure, “but would not leave behind any absolute certainty”.

“Covered bond investors might prefer a prescribed mechanism with continuation of payments to the traditional bullet covered bond with an unknown scenario of a possible asset sale in a disrupted market, which they would still be able to elect with an extraordinary resolution,” said DBRS. “The extension length will eventually be a function of the cashflows generated by the residual cover pool.”

However, it said that while a CPT structure has the benefit, for an issuer, of lowering OC requirements relative to those for a bullet covered bond, all else being equal, investors demand a premium for a CPT covered bond due to extension risk.

“The challenge for the issuer/sponsor is to educate both traditional covered bond and traditional RMBS investors so that such a premium can be minimised,” it said.

However, secondary market levels for NIBC’s CPT issue from October suggest that issuers do not necessarily have to pay up for a CPT covered bond, according to Maureen Schuller, head of covered bond strategy at ING Bank.

“NIBC Bank’s CPT covered bond issued last year is in our view evidence that for investors the advantage of a triple-A rating outweighs the premium required for extension risk,” she said. “The NIBC 1.75% 10/18 is bid today at z+33bp, i.e. 3bp through the SNS Bank covered bond curve, while SNS Bank is on average better rated and a Dutch state owned bank entity.”

NIBC is rated BBB- by Fitch and Standard & Poor’s, the latter having the rating on negative outlook, while SNS Bank is rated Baa3, BBB+ and BBB by Moody’s, Fitch and S&P, the latter assigning a negative outlook.