Oct. 2 (Bloomberg) -- The $600 billion AAA covered bond market, which contracted by 40 percent during the credit crisis as European issuers slid to junk, is seeking a comeback with structures that prevent fire sales of assets.
NIBC Holding NV, whose owners include private equity firm J.C. Flowers & Co., won a top grade for 500 million euros ($678 million) of the first new type of mortgage-backed debt yesterday, four levels higher than for its existing covered bonds and nine above the Dutch lender’s BBB- issuer rating, according to data compiled by Bloomberg.
The NIBC securities differ from traditional covered bonds because in the event of default the five-year securities can be extended by as many as 32 years, giving more time to pay investors. The 250-year-old covered bond market was badly hurt during the credit crisis, with downgrades leaving less than 60 percent of the securities with a AAA rating, down from more than 90 percent in 2010, Royal Bank of Scotland Group Plc data show.
“We are a market that is traditionally averse to change but if new technology can help us keep a AAA rating, how can we not be interested in it?” said Richard Kemmish, head of covered bond origination at Credit Suisse Group AG in London.
NIBC paid 50 basis points more than the benchmark mid-swaps rate for its debt, compared with a spread of 180 basis points that Italian bank Credito Emiliano SpA, which is also rated BBB- by Standard & Poor’s, paid to sell 500 million euros of seven- year covered bonds in July.
Issuance of the notes slowed this year to 156 billion euros, the least since 2001, as lenders trim balance sheets and central banks flood the financial system with cheap funds. The average yield on the securities fell to 1.74 percent, the least since June 6, Bloomberg bond index data show.
NIBC’s so-called conditional pass-through bonds are being seen as a test case for the 2.8 trillion-euro market pioneered in 18th-century Prussia. Europe’s sovereign debt crisis left issuers looking for ways to claw back top ratings and stay above minimum investor thresholds.
By adding the possibility of extending the notes, NIBC has removed a maturity mismatch between the assets backing the securities and the bond liability that can constrain ratings, according to Judit Papp at S&P in Frankfurt. Cash flows from mortgages are typically insufficient to redeem a covered bond by the time it comes due, meaning investors are also reliant on the ability of the issuing bank to pay its debt.
“We wanted to create a covered bond program with rating stability where the rating of the covered bond is de-linked from that of the issuer and therefore will remain AAA with S&P whatever happens,” said Niek Allon, associate director in the treasury department of NIBC in The Hague.
NIBC’s five-year securities, which are backed by a pool of prime Dutch residential mortgages, are identical in structure to traditional covered bonds when the issuer is solvent. Should the bank be in default when the bonds mature, and sales of mortgages backing the debt are insufficient to repay investors, the bonds will be extended.
“For a less well-rated bank, it can be harder to get a top rating on a conventional covered bond, but with pass-through bonds you are less reliant on the credit quality of the issuer and more on the assets in the pool,” said Mauricio Noe, head of senior and covered bonds for Europe, the Middle East and Africa at Deutsche Bank AG in London.
While the pass-through structure increases the likelihood bondholders will get their money back, it also increases uncertainty around the timing of that repayment, according to Ruben van Leeuwen, an analyst at Rabobank Groep in Utrecht.
The structure of the bonds spares holders from fire sales to recoup their principal that can occur with conventional notes. All cash flows of the underlying mortgage payments will be used to pay coupons and redeem the bonds in a default, the home loans can be sold if the proceeds are sufficient to pay back investors without a loss.
“The real story in my view is not only about NIBC, but about what a credit rating expresses and what value it brings,” said Ralf Burmeister, a Frankfurt-based fund manager at Deutsche Asset & Wealth Management, which oversees 944 billion euros. “The AAA ratings of NIBC’s bonds show it is not only about default risk, but also about the probability of getting your money back.”
--Editors: Michael Shanahan, Shelley Smith