Conditional Pass-Through Covered Bond
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.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- What are Fixed Income Securities?
- Types of Fixed Income Securities
- Types of Coupon Rates in Fixed Income Securities
- Cash Flow Types in Fixed Income Securities
- Bond Indentures and Covenants
- Types of Covenants
- Common Restrictive Covenants in Fixed Income Securities
- Embedded Options in Fixed income Securities
- Zero-Coupon Bonds: Pros and Cons
- Step Up Bonds: Pros and Cons
- Payment in Kind Bonds - Advantages, Disadvantages and its Types
- Treasury Inflation-Protected Securities (TIPS)
- What is Convertible Debt?
- Advantages and Disadvantages of Convertible Debt
- Accounting for Convertible Debt
- Reverse Convertible Bonds
- Advantages and Disadvantages of Reverse Convertible Bonds
- High Yield Bonds
- Advantages and Disadvantages of High Yield Bonds
- Preferred Shares: An Introduction
- Advantages and Disadvantages of Preferred Shares
- Covered Bonds
- Conditional Pass-Through Covered Bond
- Why do Investors Hold Fixed Income Securities?
- What are STRIP Bonds?
- What are Sustainability Bonds?
- Pandemic Bonds
- Municipal Bonds
- What are Eurobonds?
- Yield To Maturity (YTM)
- Yield to Call
- Introduction to Yield Curve
- Inverted Yield Curve
- Bond Duration
- The Calculation of Bond Duration