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New wine in old bottles (continued)

15 August 2017
Richard Kemmish

So we will have to upgrade most of the old covered bonds to the new European rule book (see previous post), the question remains: how?

This should be easy if the bonds governed by the new directive are better than those that exist today. This is ostensibly true. However, every covered bond law has strengths and weaknesses. Most obviously, weaknesses are often compensated for by more over-collateralisation. But the same can be said about any feature designed to address a problem from derivatives to liquidity rules.

The new rules may be a net benefit for every bond, but will involve losing some existing protection. Investors have their own opinions on what is important. Who is to judge whether the net effect outweighs specific losses?

To pick on Spain, the 25% minimum over-collateralisation that is currently needed is more than will be needed in the new regime. Does that mean you can just take it away from existing bonds?
Every case will differ but broadly speaking I can see five approaches to the problem.

The easiest way, in simple uncontroversial cases, is to include a clause in the new covered bond law saying that bonds structured under the old law are now bonds structured under the new law – keep your ISIN number the same and allow the programmes to be updated accordingly. Easy. However it does open up the government to legal challenge from disgruntled investors. At least two governments that I am aware of have already received legal advice that this could be problematic.

Secondly, many programmes have a bond trustee who can consent to changes if they are net beneficial. Again this opens them up to litigation risk. Bond trustees that I know tend to be reluctant to take on that sort of thing. Or they could hide behind....

... option three: the bond trustee can always initiate a change consent solicitation by bond-holder vote. We have seen plenty of these in the covered bond market recently. Where it is allowed and when the majority of bond holders can impose their will on a minority, this is the safest way to change a programme. However, it is expensive, isn’t allowed by all programmes, creates the possibility of ‘hold-outs’ in others and, as we have seen too often recently, votes don’t always give the right answer.

If that doesn’t work you could simply offer investors the switch – bring in your old bonds; get new ones. New ISIN, same coupon and maturity (and just a few cents incentive fee). That can work if you have a mechanism to ensure 100% take-up. Otherwise all of the problems of dual programmes outlined in my previous post are still there. They are just more frustrating because they are for less bonds. This approach emphatically will not work in countries where retail investors own bonds.

Finally, some sort of compromise can be arrived at via a transition period – maybe two years? – in which the old bonds continue to have all of the benefits that they currently enjoy. If you don’t like the new rules, you’ve got two years to sell the bonds. Not ideal but a pragmatic compromise.

This debate is just beginning. I suspect that it’s going to keep lawyers very busy for the next few years.

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