Harmonisation of European covered bond legislation has once again gained momentum in recent months, with amendments being made at national level. National covered bond laws, which at a detailed level are quite varied, must be adjusted to reflect the European Covered Bonds Directive by 8 July of this year. The changes must be implemented at national level no later than July 8, 2022. The objective of harmonisation efforts was, and remains, to establish uniform standards across all existing covered bond legal frameworks and to increase protection for investors, while at the same time leaving room for asset class innovations.
In its current form, the German Pfandbrief Act already sets very high hurdles for issuance of covered securities. It is therefore no surprise that it’s often referred to as the benchmark for covered bond issues internationally. Nevertheless, adjustments will also be made to the Pfandbrief Act in due consideration of the European Covered Bonds Directive.
In the case of the Pfandbrief, adjustments to reflect the EU Covered Bonds Directive will be made through the CBD Implementation Act (CBDUmsetzungsG), which will contain the relevant amendments to the Pfandbrief Act. Below we take a closer look at what we consider to be the most important points from an investor’s perspective. At the time of publication, the final readings of the bill in the Bundesrat had not yet taken place. However, we assume that there will be no further changes of material significance to investors.
Important changes to the German Pfandbrief will already come into effect on July 1st this year. From the investor’s standpoint, the first thing to note is the statutory maturity extension by up to 12 months (“soft bullet”) for Pfandbriefe, which has been introduced in section 30 Pfandbrief Act. Unlike at international level, up until now Pfandbriefe have only been issued with a fixed repayment date (“hard bullet”). Once introduced, the maturity extension will apply both to existing and to newly issued Pfandbriefe. It is important to note that bonds already outstanding will not be grandfathered. This is noteworthy to the extent that – regardless of substance – retroactive changes to the terms and conditions of existing securities have generally been met with criticism from many investors. To date, issuers internationally in many cases have rewarded changes in repayment methods with an additional special payment for creditors. This will not be the case for Pfandbriefe. So how should we assess the maturity extension?
For us, the most important criterion for assessing extension of maturity is the question regarding the issuer’s right to choose. On this point, the new section 30 clearly states that only the cover pool administrator may extend the maturity of Pfandbriefe in order to avoid insolvency of the Pfandbrief bank with limited business activity. Therefore, an optional right of the issuer to choose a maturity extension is barred. In our view, this strengthens the Pfandbrief creditor’s position in the event of bankruptcy. In this case – and only in this case – the cover pool administrator is given the opportunity to extend the maturity to ensure full servicing of Pfandbrief investors’ claims by creating liquidity during that period. Immediate insolvency is thus avoided.
The alternative to a uniform rule would have been that, in the future, Pfandbriefe from the same issuer would be traded on the market with different repayment profiles. Given the current tight interest rate environment, it can be assumed that in this case, there would nevertheless not have been any noteworthy price differences between varying maturity profiles. However, investors would also have to inquire about the maturity structure before every investment. In some cases, there might be additional differences in the rating of an issuer’s individual securities, depending on the maturity profile. On a positive note it is certainly true that, given the high ratings Pfandbriefe enjoy internationally, there is no suspicion that the motive behind a “soft bullet” mechanism is simply the desire to obtain an even better rating. From this point of view, uniform regulation should be given precedence, precisely because the change applies to all Pfandbrief issues. The above notwithstanding, making changes to bond terms without any compensation must continue to be the exception, in particular if such changes are made only by a single issuer.
As for the payment of interest during the period of extension, the new section 30 provides – subject to any agreements to the contrary – for interest to be paid under the terms and conditions stipulated in the bond terms and conditions that applied up to the date of the extension. The respective (future) bond terms and conditions must be consulted regarding which terms and conditions apply to future issues and whether separate provisions apply in the case of such extension.
In order to prevent liquidity bottlenecks from occurring in the first place, the previous version of the Pfandbrief Act already included in section 4, a provision to ensure liquidity for the next 180 days. This provision is an important element of investor protection. Accordingly, the differences between claims related to the cover assets and Pfandbrief liabilities for the next 180 days are added up. Negative balances must be covered by assets deemed eligible by the central bank. In this regard, we believe that an important aspect is our interpretation that the liquidity requirements continue to be based on the original maturity date and not on the new legal maturity extension. As discussed in article 16 of the Directive, in the new version of the Pfandbrief Act, unsecured receivables that have already defaulted may not be counted as part of the liquidity buffer.
In 2022, the introduction of a minimum 2 % nominal overcollateralisation for Mortgage and Public Pfandbriefe will become mandatory. For Pfandbriefe secured by ships and aircraft, the future nominal overcollateralisation will be 5 %. The net present value of overcollateralisation of 2 % in section 4 remains unchanged. Article 15 of the Directive will be implemented in 2021; cover requirements also include the costs of potential resolution of the covered bond. Here again, unsecured receivables that have already defaulted may not be included in the cover. Therefore, from the investor’s perspective the changes satisfy the requirements of the EU Directive.
In the past, covered bond investors and issuers repeatedly held discussions about possible dilution of the product and opening it up to include new cover assets. In our opinion, it is extremely positive to note that the amendment maintains the cover assets previously established in the German Pfandbrief Act. The additional options for eligible cover assets under article 6 of the EU Directive that exist in principle do not apply. Furthermore, section 26 of the new amendment explicitly orders the avoidance of critical concentrations when taking aircraft assets as collateral.
Naturally, even the current changes relating to harmonisation of the covered bond market are not comprehensive or final. In our view, the issue of providing liquidity for covered bonds trading is not being adequately addressed either in the EU Regulation (CRR) or in the Directive or in the Amendment to the Pfandbrief Act. There is a noticeable trend towards smaller and smaller issue sizes (aka “no grow”). Many issuers have received adequate funding (and under record conditions) through the latest TLTROs, so further borrowing through Pfandbriefe is being postponed until later or is occurring only in small volumes. It would have been preferable to introduce a minimum issue size of EUR 1 billion for premium covered bonds under the CRR. To date, the European Central Bank has acquired around EUR 290 billion of covered bonds, which is gradually reducing market liquidity, in particular where small-volume issues are concerned. In our view, introducing a minimum issue volume would have a positive impact on the provision of liquidity for covered bonds. At the same time, only issuers with a large enough portfolio of assets eligible for cover would have access to the premium segment (“European Covered Bond Premium”). Covered bonds below a specified issue volume would fall under the “European Covered Bond” segment.
Increasingly, investors are seeking investments in sustainable covered bonds (Environment, Sustainability and Governance – ESG). While the EU Taxonomy Regulation offers a rough framework for green investments, details on calculating buildings’ energy efficiency are not regulated in a uniform manner from country to country. ESG covered bonds are currently being marketed around the world in a variety of forms, including sustainable, social or green bonds. It would be desirable to incorporate standards for ESG Pfandbriefe into future versions of the Pfandbrief Act in order to distinguish Pfandbriefe from the competition in this respect as well.
To date, technical challenges have also not yet been addressed through harmonisation and the amendment. The path to a token economy is no longer an abstract notion, as the huge increases in efficiency that this can yield are obvious. How should digital asset rights (asset tokens) to covered issues be generated and managed in a legally secure way in future and which market players need to participate in decentralised digital networks? On which consensus mechanisms, proof of work, proof of stake or others will the network be based? Serious, sustainable and, importantly, timely efforts will be required here to ensure that the Pfandbrief remains viable in the future.
From the investor’s perspective, this amendment to the Pfandbrief Act represents another qualitative reinforcement of the Pfandbrief. Nevertheless, given current Pfandbrief spreads which are extremely narrow, we do not expect the changes to cause any further narrowing of spreads. At a legal level, everything has been done to ensure the continued strength of the Pfandbrief product. What is now required is a market environment that also provides investors with an attractive investment opportunity. Only time will tell whether in the future, once again, Pfandbriefe – along with bank treasury investments driven by the ECB’s asset-purchase programme and the LCR – will increasingly be included in the investment strategy of real money investors such as insurance companies and pension funds.
All investments entail risks and may lose value. Bond market investments are exposed to risks, such as market, interest rate, issuer, credit, inflation and liquidity risks. The value of most bonds and bond strategies is affected by changes in interest rates. Bonds and bond strategies of longer duration are often more sensitive and volatile than securities of shorter duration; as a rule, bond prices fall if interest rates rise, and the current environment of low interest rates increases this risk. Decreases in the creditworthiness of the bond counterparty may contribute to lower market liquidity and higher price volatility. At redemption, the value of investments in bonds may be higher or lower than the original value. Because of the risk of premature repayment, mortgage-backed and asset-backed securities may be sensitive to changes in interest rates, and even though they are usually secured by a government, quasi-government or private guarantor, there is no guarantee that the guarantor will satisfy its obligations. Corporate debt securities are exposed to the risk that the issuer will not be able to satisfy its obligation to make principal and interest payments associated with the bond, and may be subject to price volatility due to factors such as interest sensitivity, the assessment by the market of the issuer’s creditworthiness and overall market liquidity. Investments in securities denominated in foreign currencies and/or issued abroad may be riskier due to exchange rate volatility as well as economic and political risks. This applies, in particular, to emerging markets. Exchange rates may fluctuate significantly within short periods of time, reducing portfolio returns. The credit quality of a certain security or group of securities does not guarantee that the entire portfolio will be stable or safe.
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