Chilean covered bond legislation offers substantially less protection that expected by covered bond investors used to other modern frameworks, said Fitch yesterday (Monday), citing shortcomings related to discontinuity risk and overall recovery potential.

A dedicated framework for covered bonds, called bonos hipotecarios, was introduced in Chile in 2012 and inaugurated by Banco Santander Chile on 1 August. The bank sold a UF1.5m ($67m, Eu50m) 15 year deal in the domestic market, and has said it may launch a second transaction later this year. (Select Chile from the country dropdown menu for further coverage.)

Banco Santander Chile

“While the new legislation shares similarities with other covered bonds frameworks, it offers less protection to investors used to other modern frameworks,” said Juan Pablo Gil, senior director at Fitch.

The rating agency said that the new framework “falls short of the mark”, offering little protection from the insolvency of the issuer, with investors unlikely to be able to receive timely payments should the issuer fail to settle payments when due.

“While this dedicated framework provides bondholders with statutory preference to a set of identified cover assets, access to these assets is only indirect and the process remains unclear,” said the rating agency. “Furthermore, bondholders are not protected from liquidity risk post-issuer default and do not benefit from a third-party administrator.”

With respect to access to cover assets in the event of an issuer insolvency, Fitch noted that the registered assets may not be separately managed to allow cash flows to continue to repay the mortgage bonds. The portfolio can be purchased by an acquiring bank, which will assume the payments on the mortgage bonds. This could cause interruption in bond payments, said Fitch.

It also noted that although some eligibility criteria exist for the covered bond collateral, the future composition of the cover assets is largely unknown at issuance. This is because under the Chilean legislation banks issue covered bonds and then use the funds raised to originate eligible mortgage loans (mutuos hipotecarios).

Another weakness is an absence of overcollateralization, as the cover pool may not exceed outstanding mortgage bonds, according to Fitch.

“This lack of positive OC, together with uncertainties regarding the actual mortgage portfolio characteristics, prevents Fitch from giving significant credit to recoveries if the mortgage bonds default and limit ratings uplift,” said the rating agency.

Fitch also noted an absence of liquidity mechanisms and a substitute administrator following issuer insolvency, and a generous valuation of cover assets under the new framework, with full credit given to mortgages with a high level of delinquency.