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Conditional pass-throughs: the dangers of diversity

26 July 2017
Richard Kemmish

The recent Bank of Queensland deal has, as was argued by Bill Thornhill in GlobalCapital, added yet further to the structural diversity that is the conditional pass-through market. He also suggests that this is potentially problematic for the goal of regulatory preference for the bonds. Is he right?

Whether or not conditional pass-through bonds continue to benefit from top-tier preferential treatment is a decision that will almost certainly be made by the EBA. Conveniently, they have explained their objections to the concept so that we can consider whether they are objections to the concept per se, or objections to the (diverse) way in which it is currently done.

Specifically, the EBA say that investors should be concerned about a longer theoretical maturity, complex amortisation profiles, difficult pricing and illiquidity (in the sense of the transfer of refinance risk to the investors rather than secondary market liquidity).
The longer theoretical maturity appears to be an ex ante concern – does my investment mandate allow me to buy a bond with a long final legal maturity, even if the expected maturity is far shorter? The ex post reality of course is that conditional pass-throughs won’t in practice be that long. And that traditional ‘hard bullet’ covered bonds could just as easily be. If the European Commission follows the EBA’s suggestion on trigger events (I think it should) it seems bizarre to define the legal final maturity of the bond with reference to anything that might happen after the issuer’s default.

Again, the complex amortisation profiles that the EBA are concerned about won’t actually happen in practice. Or if they do, they are no more complex or unpredictable than what would happen in any other wind-down scenario. Or did the EBA mean by that, that the complexity is a function of the different rules that apply in different programmes, and the need to get comfortable with them on day one? If so, they have a point.

The next of the EBAs concerns is perhaps the weakest: pricing. Yes, I know we are in an abnormal market but the experience of these structures so far suggest no problem and little differentiation in the pricing of these structures. Similar (or in some cases the same) issuers with both conditional pass-though and soft or hard bullet bonds show no meaningful price differentiation.

The final point is perhaps the most significant. The uncertain pay-down of the assets becomes a problem for the investor when it properly belongs to the issuer. Again though, this is only a problem after the failure of the issuer. The covered bond market is providing term matching to the aid of the insolvency estate of the issuer or, more likely, the issuer in one of the resolution scenarios. When considered with the lower over-collateralisation that conditional pass-throughs require this suggests that, at very least, unsecured creditors and resolution authorities should have a preference for the conditional pass-through structure.

There is no simple answer. But to me the ‘day one’ complexity caused by the divergence of structures currently in the market is far more of a concern than any of the substantive objections of the EBA.

In other words, Bill was right.

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