Mitigating Covered Bond Extension Risk

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