Mitigating Covered Bond Extension Risk
Richard Kemmish
30 years: Capital markets & covered bonds
One of the problems from the popularity of soft-bullet maturities is that in the process of adapting it in different countries, there has been diversity about the finer details. In the final part of his Covered Bond series, Richard looks at how long the extension period should be, what interest rate is applied during the extension and which remedial actions must be taken.
One of the problems from the popularity of soft-bullet maturities is that in the process of adapting it in different countries, there has been diversity about the finer details. In the final part of his Covered Bond series, Richard looks at how long the extension period should be, what interest rate is applied during the extension and which remedial actions must be taken.
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Mitigating Covered Bond Extension Risk
9 mins 11 secs
Key learning objectives:
Define natural hedging, pre-maturity tests and refinancing gaps
Explain how conditional pass throughs and soft bullet structures mitigate extension risk and their drawbacks
Identify the features of extensions
Overview:
A prevalent issue with covered bonds is the refinancing risks that arise from mismatches in time between when assets pay down and the fixed maturity date of the bonds – to mitigate this, structures such as soft bullets and conditional pass throughs are used.
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What is a refinancing gap?
A refinancing gap is when a bond matures, and the portfolio hasn’t generated enough principal to repay it.
What is natural hedging?
If the pre-payment of the assets backing the bonds is relatively certain, an issuer can attempt to match the pre-payment of the portfolio with the pre-payment of the bonds backing it.
What are pre-maturity tests?
In the run-up to a bond’s maturity, the short-term rating of a bank is tested to see if it is good enough to refinance the bond. If it isn’t, they must take remedial action, such as posting cash or finding a well-rated guarantor of the bonds. However, with this structure, if the bank defaults, the refinancing problem still exists.
What is the soft bullet covered bond?
Under this structure, if a bond reaches its maturity date and the issuer is unable to repay the bonds, the bond automatically extends for a short period of time – typically 1 year on a rolling 1-month extension basis at a punitive floating rate.
What are some of the issues with structuring soft bullet covered bonds?
- How long should the extension period be?
- What interest rate is applied during the extension?
- What remedial actions must be taken?
- How to handle other bonds that haven’t reached their maturity date
- What triggers can cause an extension?
What is conditional pass through covered bonds?
The idea is to remove the fixed extended maturity date of the soft bullet structures and allow the bonds to repay from the mortgages as long as investors do not actually lose any money.
What are some of the issues with structuring conditional pass through covered bonds?
- Do all bonds automatically extend if one does?
- Is there the possibility of an event of default and the resultant acceleration of all bonds outstanding?
- Does the extension of a bond automatically trigger an issuer event of default?
- How are assets shared between bonds paying down and bonds still waiting for their final maturity?
What are the features of extensions?
- Should not be triggered at the discretion of the issuer
- Should be specified, either in the covered bond law or the programme documentation
- Should not contradict any of the other principles of covered bonds
- Investors should have sufficient information about the extension and the possible final maturity date
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Richard Kemmish
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