New Twist on Covered Bonds Meets Rating Approval

A new twist on the traditional covered bond structure is designed to increase the probability that bond obligations will be met even if the issuing financial institution becomes insolvent.

For issuers, a big advantage is that the twist—a so-called “partial pass-though” structure—can help a covered bond issuance keep its rating independently from the strength of its issuer.  Such a rating reflects a perceived higher probability that obligations to bond investors will be met despite an issuer’s possible difficulties.

“Pass-through structures are advantageous for issuers because the covered bonds will often have a higher rating cap relative to the issuer,” Suzanne Albers of Fitch Ratings is quoted as saying in a public announcement.  “As a result, there will generally be a greater cushion before a downgrade of the bank would impact the covered bond rating.”

Typically, covered bond investors receive a return of principal in a lump sum (bullet) when the bonds reach maturity.  The pass-through structure comes into play if the bond is not redeemed on its expected “bullet maturity” date.   In that situation, the investors’ principal can be repaid over time on a pass-through basis directly from the periodic payments made by borrowers on the loans in the cover pool.  Also, principal payments made by borrowers can be used to pay interest obligations to the investors—a so-called “combined waterfall.”

In combination with an ability to extend a bond’s maturity period beyond the expected “bullet maturity” date, the pass-through structure adds a great deal of flexibility to help ensure that covered bond investors ultimately will be paid in full.  This is seen as particularly important in an economic climate where prospects for liquidating assets in a cover pool are uncertain.

Norwich & Peterborough Building Society (in the UK) issued covered bonds with a pass-through structure on Jan. 15, followed by the Newcastle Building Society on Jan. 19.  According to Fitch Ratings, those are the first two covered bond issuances in the UK to have this structure—and the first ever rated by Fitch.  The agency rated both issuances AAA.

Fitch has made a special announcement saying it sees the pass-through structure as a trend that it expects will continue.  Helene Heberlein is quoted as saying that while the two issuers used the structure solely to access funding from Britain’s central bank, “the continued use of these features may present a more predictable risk profile for investors, due to the reduced potential for rating volatility.”

To read the following press releases from Fitch Ratings, first log in (free) at www.fitchratings.com, then click on an item below:

“Fitch on Norwich & Peterborough Covered Bonds”

“Fitch Rates Newcastle Building Society Bonds”

“Fitch: Covered Bond Trend to Continue”