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2019-09-23 18 ENGLISH REPORTS
European securitisation bonds typically amortise over time through the repayment of the underlying exposures (a notable exception to this are UK credit card and UK and Dutch mortgage master trusts, which offer investors soft-bullet bonds). Distributed covered bonds typically utilise a hard or soft-bullet redemption profile (there are some pass-through covered bonds, but these have typically been retained by originators for use as central bank repo collateral). Increasingly however, ‘hybrid’ instruments known as Conditional Pass-Through (CPT) bonds are being used, which combine a scheduled soft-bullet maturity, with a pass-through 'tail' following institutional default. Credit enhancement & Investor protections Covered bonds are less structurally engineered than even the simplest type of passthrough securitisation vehicles (even setting aside the complexities of ABS master trusts). To this end, covered bonds do away with much of the credit enhancement offered to securitisation investors (subordinated tranches, reserve funds, excess spread, etc). Rather, covered bond investors’ main form of credit enhancement stems from programme over-collateralisation (which is naturally dynamic based on issuer actions, including collateral additions and the programme’s issuance/redemption profile).
Unlike in securitisations, where credit enhancement tends to increase over time as the structure delevers (barring collateral credit issues and the specific case of master trusts), over-collateralisation in covered bond programmes can increase or decrease as the programme is utilised by the issuer. Further investor protection is provided to CB investors by tests adopted in local legislation or programme terms. For example, ‘structured’ covered bond programmes (i.e. Canada, the Netherlands, the UK, etc) typically require that the assets of the guarantor entity are subject to an Asset Coverage Test (ACT) on a regular basis. The test is designed to ensure a minimum level of over-collateralisation in the cover pool to protect investors from market and liquidity risks. The guarantor must therefore ensure that on each calculation date, the ‘Adjusted Aggregate Loan Amount’ (i.e. the aggregate loan amount haircut by predefined criteria) is at least equal to the outstanding amount of the programme’s CB. The ACT is conducted by the Cash Manager, with annual third-party asset monitor reviews. Failure to remedy a breached ACT by the next calculation date usually results in an Issuer Event of Default. Similarly, programmes from these jurisdictions also typically include an Amortisation Test (AT), which is designed to ensure that the cover pool exceeds the outstanding notional of CB at all times.
The adoption of an AT serves to minimise time subordination within the structure for outstanding noteholders. Following service of a Notice to Pay on the guarantor, it must ensure that on each calculation date following an Issuer Event of Default, the Amortisation Test Aggregate Loan Amount will at least equal the aggregate outstanding amount of the CB. Other tests offering protection to bondholders include ‘Pre-maturity Tests’ (which are designed to ensure the borrower can provide sufficient liquidity in case of downgrade (i.e. pre-defined period prior to scheduled bond redemption, if a borrower’s short-term rating is below a prescribed threshold, the borrower must fund a cash collateral account to ensure redemption)); and ‘Interest Coverage Tests’ to ensure interest from the cover pool after hedges always exceed interest payments due on the covered bonds over a given period.
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