While covered bonds are essential for protection, understanding the structure of those bonds is just as necessary. In this article, we will look through how covered bonds are usually structured to give you a better understanding of what you should look for.
Of course, bankruptcy protection for any kind of loan is an important factor. Covered bonds are already commonplace in Europe, and they are becoming more popular throughout the US, as time goes by.
Corporate and Covered Bonds
The best way to describe a covered bond is to say it is a corporate bond with an additional enhancement. That enhancement is recourse to a pool of assets which covers, or secures the bond.
That cover is to act as an additional credit cover should the issuer become insolvent. Unlike scrutinized assets, the assets in covered bonds do not change any contractual cash flow to the investor.
There is a significant advantage to a covered bond for the investors. That is the asset pool and the debt remains as a financial obligation to the issuer. Therefore, the issuer needs to ensure that the covered bonds are continually backed up by the pool. That means that, if there is a default, the investor has the ability to appeal to the issuer and the pool.
All variations and levels have redemption management strategies. However, there are three main types of strategies or regimes that companies will use. Those three are harmonized definitions of the words, so they are the words that you would expect to see. Here we will look at those three individually.
Hard bullet covered bonds are, as the name suggests, the strictest of the three. All hard bullet covered bonds are repaid on the maturity date, and there is no documentation or legal structure for extension of that date.
Failing to repay the final amount of a hard bullet covered bond on the date of maturity can provoke a default of those bonds. Furthermore, it may result in the liquidation of the pool. However, that will depend on the insolvency rules of the area.
Soft bullet covered bonds are similar in structure to the hard bullet. However, only in the fact that they also have a scheduled maturity date. What happens on that date is the difference.
If some predefined criteria are met at the set maturity date, the maturity date can and often does get extended to a preset date. During that extension, the covered bond can be reclaimed using the cover pool.
Sometimes, soft bullet covered bonds have multiple extensions. However, at the end of the single, or multiple extension, the soft bullet covered bond will act as a hard bullet covered bond.
Conditional Pass-Through (CPT) Covered Bonds
Conditional pass-through covered bonds still have a scheduled maturity date. However, they also have an extension system in place. Failing to repay the bond on that date does not result in acceleration of the bond. However, conversely, it leads to an extension of the maturity date to the specific, and possibly other attached bonds.
All of the other attached bonds will only be affected and go into “pass-through mode” at the date of their Standard Maturity Date (SMD)
As with the soft bullet bonds, the extension requires to meet predefined criteria. That extension can continue to a maximum maturity date which is usually linked to the maximum maturity of the asset.
CPT covered bonds will often allow a much lengthier repayment date as the structure allows for it. Postponing the date for longer amounts of time will reduce the refinance risk, too.
Conversely to the soft bullet structure, the pass-through structure aims to cover the bond from generated inflows of the asset, followed by the sale of them if the price is feasible.
Furthermore, the worst-case scenario of investor claim amelioration is determined by the assets maturity date of the most extended term.