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Hard to define

12 December 2016
Richard Kemmish

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, I’m 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 isn’t always a year) or what rate you get during that extension period (it isn’t always one month libor, I even found a specimen that paid a fixed rate during an extension period – a true collector’s 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 going concern.

Some soft bullets work on a ‘gone concern’ basis: after a default they attempt to ameliorate the effects of that default. I’ve 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 entity’s 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.

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