MSG Team's other articles

9289 Factors to Consider While Using the Retail Inventory Method

The retail inventory method is used by retail corporations across the globe to obtain a rough estimate of the ending value of inventory held by them. However, the cost price is calculated as a percentage of the sales price. Since the sales price fluctuates significantly over time, calculating the estimated cost price can become a […]

11002 Reverse Factoring – Meaning and its Benefits

The purpose of commercial banking is to help corporations meet their funding needs in a better manner. Commercial banks help companies do this in several ways. One such way is related to the concept of reverse factoring. Reverse factoring is a solution that helps large corporations manage their supply chains better by helping optimize the […]

11461 Sweeping – Meaning, Need and Types

We are already aware that commercial banks are offering several liquidity management services to their clients. In the previous article, we have already studied how notional pooling can help corporations better manage their liquidity. However, notional pooling is not the only option. In fact, there is another option called “sweeping” which is used by the […]

12370 Artificial Intelligence in Commercial Bank Lending

We have already seen the various ways in which technology has shaped the commercial banking domain. However, the commercial banking domain is so vast that it is being concurrently affected by many big changes. The increasing use of artificial intelligence for commercial lending is another important trend that is impacting the commercial bank lending industry. […]

11702 Types of Sponsorships Given to Individual Players

In the previous article, we have already seen that sponsorship is one of the predominant ways in which a sports league can generate revenues. However, it is important to note that sponsorships can happen at various levels. For instance, sponsorship can be given to an individual, a team, or even an entire sports league. In […]

Search with tags

  • No tags available.

In one of the previous articles, we studied about covered bonds. We discussed how covered bonds are considered to be safer as compared to asset-backed securities. We also explained how having double recourse makes covered bonds virtually risk-free and gives investors the confidence they require to invest their money even if they end up getting a low yield.

However, there are some problems which issuers, as well as holders of covered bonds, have to face. In order to get rid of these problems, a new type of covered bond called conditional pass-through covered bond has been created. In this article, we will have a closer look at this new type of bond.

The Problems with Covered Bonds

Covered bonds are created in such a way that the possibility of default becomes quite remote. This is because covered bonds have dual recourse. Hence, if the cash flow from the bonds is not sufficient to pay the debt, the investors have recourse to a pool of assets that have been set aside. This pool is often known as the cover pool. If the cover pool is also not sufficient to pay the debtholders, then the liability falls upon the issuer who is required to maintain the covered bonds on their books.

Now, in theory, it is quite simple to liquidate assets from the cover pool and use the proceeds to pay investors. However, time and again, bond issuers have found out that such changes are quite difficult to implement in real life.

This is because the assets that form the cover pool are quite specialized. This means that there are only a limited number of buyers who have any use for those assets. However, at the same time, the seller is facing a time crunch to sell the assets. They need to make payments before a certain date in order to avoid default.

The end result is that the buyers are aware that the seller is short of time. As a result, they often collude and make very low bids to acquire the asset. Since the seller is faced with a paucity of time, they are forced to make a distressed sale at a very low price.

The end result is that both the bondholders as well as the equity holders of the company suffer. At the same time, the group of buyers who have purchased assets at rock bottom prices stands to gain.

Credit rating agencies are also aware of such situations. Hence, they only give good credit ratings to covered bonds if they are heavily collateralized. This ends up with the company deploying its assets in a sub-optimal manner. The conditional pass-through securities have been created in order to overcome the issues related to such fire sales.

How Conditional Pass-Through Covered Bonds Help?

Over time, all stakeholders have realized that in the event of a default, there is no use in placing a time limit on the seller in order to liquidate the assets. Such a time limit only encourages prospective buyers to bid lower which ultimately causes a loss to all stakeholders involved.

Hence, in order to prevent this artificial time limit, investors have now created a system wherein covered bonds will have a pass-through structure. In simple words, this means that in the event of a default, if the borrower is not able to pay back the money by the end of a certain period, then the ownership of the assets will pass through to the bondholders.

Now, since the entire ownership passes on to the bondholders, they would want to sell the assets at a fair value in order to liquidate their stakes. However, unlike the previous arrangement, the bondholders will have an incentive to wait till a fair offer is obtained before selling off the assets.

By providing the ownership of the assets to the bondholders, the effect of a self-imposed artificial time limit is reduced to a great extent. As a result, prospective buyers also have no incentive left to collude and drive down the prices. The end result is that more value is retained by the stakeholders of the company and a lesser value is lost as a result of the panic which has been created.

Benefits of Conditional Pass-Through Covered Bonds

  • One of the benefits of conditional pass-through-covered bonds is that even if one particular tranche of bonds faces cash flow issues, the issuer is not considered to be bankrupt. The other tranches are still not considered to be bankrupt as long as payments are made as per the previously agreed upon cash flow schedule. The ability to treat each tranche of bonds separately is very important to investors.

  • Since the amount of value lost in fire sales is less as compared to a regular default, the issue of conditional pass-through covered bonds requires less over-collateralization. This means that the borrowing firm can use the same assets to issue more bonds and hence as a result raise more funds

  • Conditional pass-through-covered bonds are able to reduce the level of risk without increasing any costs. Hence, they receive better ratings from credit agencies. As a result, they are able to issue bonds with lower yields.

The end result is that conditional pass-through covered bonds are cheaper and more effective as compared to traditional covered bonds. This is the reason why their popularity is bound to increase in the forthcoming years.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Covered Bonds

MSG Team

Common Restrictive Covenants in Fixed Income Securities

MSG Team

Cash Flow Types in Fixed Income Securities

MSG Team