It is easy to underestimate the glorious diversity that is
the covered bond market. Thirteen years after first selling a
soft bullet covered bond and after thirteen years of
frustration at the lack of willingness of investors to
understand what, to me was quite a simple concept, Im
finally coming to realise that maybe I have underestimated the
diversity all along.
In my specimen cabinet I have so far collected five
varieties of soft bullet covered bond. That is, five distinctly
different species, never mind the sub-divisions within each
breed for example how long you extend for (it isnt
always a year) or what rate you get during that extension
period (it isnt always one month libor, I even found a
specimen that paid a fixed rate during an extension period
a true collectors item).
What are the more substantial distinctions between different
types of soft bullet? There are several variables: who makes
the decision and what the conditions precedent for an extension
are. Both of those hint at the more fundamental distinction
that divides soft bullet land what is it for? To draw
the analogy to bank capital, some extensions are there to
protect you on a going concern basis they exist to
prevent defaults that would otherwise be inevitable (for
example, if the bonds were hard bullet). They would argue that
the damage of a missed hard bullet and its consequences are
greater than an extension to ensure that the issuer remains a
Some soft bullets work on a gone concern basis:
after a default they attempt to ameliorate the effects of that
default. Ive heard someone who opposes that second
approach say that all they do is restrict the freedom of
actions of the special administrator and/or regulator post
default. The flipside argument is that they provide greater
certainty of regulator actions. And bondholder votes can always
change the terms if that is really what you want.
The going concern/gone concern distinction is slightly
complicated by the question about which entitys default
we are talking about? In a special bank model is it the special
bank or the sponsor bank? In the SPV holding the assets model,
is it the issuer or the SPV/guarantor? In both cases the former
is far more likely to default, and without necessarily
triggering a missed payment, than the latter.
A further different type of soft bullet is one that is
trying to avoid refinancing shocks. If I have to issue to repay
a bond, and if that new issue is effectively so prohibitively
expensive that it would (for example) cause defaults, then it
is best for all concerned if I am allowed a grace period on the
default. This is a consequence of those bonds which pass on
their funding costs to the underlying borrowers and, lets face
it, of the volatile times in which we live.
These distinctions may also be relevant to define the new
German law changes...when they are unveiled.
Soft is quite hard to define.