Uncovering OC – DBRS Releases a Commentary on Canadian Covered Bonds

DBRS has today published a commentary discussing in detail the nature of overcollateralization (OC) for Canadian covered bonds. This commentary is intended to help market participants sort through the jargon and program structures and better understand the investors’ entitlement to OC, specifically following an issuer default.

OC can be broken down into two components: mandatory and voluntary. DBRS considers Program OC to be mandatory, which is defined as the amount of OC required to satisfy the asset coverage test (ACT) and is derived from the Asset Percentage. This characterization is based on the purpose and priority of the Guarantee Loan used in Canadian covered bond programs. As the Guarantee Loan amount is, in essence, equal to the principal balance of all covered bonds outstanding plus the Program OC and the repayment of the Guarantee Loan is contractually subordinated to payment of interest and principal on the covered bonds, DBRS considers Program OC to be akin to the credit enhancement typically seen in a securitization transaction and expects Program OC to be available to investors for recourse upon issuer default.

Any OC in excess of Program OC is voluntary and is funded by the Demand Loan. As the name suggests, the Demand Loan is payable on demand, subject to the maintenance of sufficient OC to satisfy the ACT. Unlike Program OC, voluntary OC is not available to the investors after issuer default.

While the program documents for Canadian covered bonds do not have explicit provisions requiring the issuers to maintain a certain covered bond rating, issuers are obligated to use reasonable efforts to satisfy the ACT. Investors may take further comfort that, through satisfaction of the rating agency condition, the documents restrict the issuers’ ability to set Program OC below the level required to maintain the initial or current covered bond rating, as applicable. This essentially limits issuers’ ability to cause negative rating implications on the covered bonds.

The key takeaways of this commentary are that Program OC (1) is mandatory; (2) must be set to maintain the initial or current covered bond rating, which is AAA in either case for all Canadian covered bonds; (3) cannot be set below the established minimum OC; and (4) will be available to investors for recourse upon issuer default.

As the global covered bond market expands, the differences between program structures, legislative requirements and rating agency methodologies sometimes make it difficult to get to the heart of covered bonds. DBRS will continue to monitor developments of the market and provide timely comments to market participants.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.