Interview

Double interview about maturity extensions

While covered bonds with soft bullet structures have been established in many countries for years, a statutory maturity extension in Germany will be incorporated into the forthcoming amendment to the German Pfandbrief Act (Pfandbriefgesetz, PfandBG). The draft bill of the Federal Ministry of Finance contains detailed provisions on maturity extensions that transpose Art. 17 of the Covered Bond Directive. Franz Rudolf, Head of Financials Credit Research at UniCredit, and Sascha Kullig, a member of the vdp's Management Board, talk in a double interview about maturity extensions, a complex innovation in Pfandbrief legislation.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

Some comments read as though the rules proposed in the draft bill were something completely new and unusual. To what extent do the plans of German legislators differ from existing soft bullet deals, and what similarities do you see?

Franz Rudolf

Franz Rudolf

UniCredit Bank AG

The subject of maturity extensions for covered bonds has been under discussion for more than ten years. Well over half of all covered bonds are now issued with a maturity extension in the form of a soft bullet structure, so there’s nothing out of the ordinary here. However, Germany is one of the few countries still issuing covered bonds solely in the hard bullet format, i.e. with no option to extend maturity. In this respect, the bill represents an innovation for the Pfandbrief.

Although soft bullet structures now tend to be the standard rather than the exception, we actually find different types internationally. These essentially relate to the exact wording of the triggers in which maturity extensions are allowed, the length of the extension period and payment of interest during the extension period. The proposed rules for Pfandbriefe have many similarities with regulations in other countries, but also some differences when it comes to the details.

One major similarity is the total duration of an extension. Twelve months has become the established standard on the international market. The German bill proposes the same total period, though divided into blocks of four weeks and two times of six months. Another similarity is that interest will, in principle, be paid during the extension period. Here too, though, the German bill also differs slightly in one detail, as not only principal but also interest payments will be deferred in the first four weeks of the extension.

With regard to differences compared with regulations in other countries, we should mention that maturity extension in Germany is regulated in detail at legislative level. Poland is so far the only other country where this is the case. Otherwise, the regulations on maturity extensions can generally be found in the individual issuers’ documentation and final terms, but not in the national legal framework. To that extent, the German model offers the advantage of being regulated consistently and in a way that is transparent for investors.

Another difference in the international context is that maturity extensions will not be granted automatically after the issuer becomes insolvent, but are one of several measures available to the cover pool administrator to ensure that Pfandbriefe are repaid in accordance with the contract.

In my opinion, the aspects that are important to market perceptions have many similarities with other countries. The differences are due to the very detailed approach and to the fact that regulations must be adapted to conditions on national markets.

Sascha Kullig

Sascha Kullig

Association of German Pfandbrief Banks

Some elements undoubtedly represent a first compared with existing soft bullet structures. They include, as Franz has mentioned, the option for the cover pool administrator to extend all Pfandbriefe that mature within the first four weeks after his appointment until four weeks plus one day after that date. This option also extends to interest payments and is intended to give the cover pool administrator time to gain an overview of the situation. After all, before making the first redemptions or interest payments, he must be able to judge whether there is a realistic chance of servicing all outstanding Pfandbriefe in full and on schedule.

I see similarities in terms of the duration of the maturity extension. The German regulation is in good company here, as 12 months is a common time frame for an extension. Another similarity is, without doubt, the option to repay Pfandbriefe in full or in part after an extension but before the expiry of the maximum extension period.

And, ultimately, the consequences that will ensue if the outstanding covered bonds or Pfandbriefe are not repaid even after the extension period has expired are likely to be similar. In Germany, special insolvency proceedings would be commenced for the affected Pfandbrief bank with limited business activities, and in other countries, too, the result would be the default of the issuer or the cover pool.

However, one very important difference compared with existing soft bullet structures is legal regulation under the German Pfandbrief Act. With very few exceptions, soft bullet structures in other countries have to date been anchored contractually in the individual covered bond issuers’ documentation and have had no statutory basis. This sometimes leads to uncertainty about whether the “trigger” prompting the extension gives the issuer discretionary leeway. The Covered Bond Directive will no longer allow such leeway in future.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

The legal text on maturity extensions in the draft bill is relatively complex. Do you think the regulation could be simplified, or is there a reason for the complexity?

Franz Rudolf

Franz Rudolf

UniCredit Bank AG

Simple and comprehensible regulation is generally preferable. This makes the details easier to understand, not only for lawyers, cover pool administrators and issuers, but also for (international) investors, rating agencies and, not least, analysts.

We shouldn’t ignore the fact that, besides German investors, who have been familiar with the details of the German Pfandbrief Act for decades, there are also many international investors who would like to gain a quick and thorough understanding of how Pfandbriefe regulations work. The reasons for the complex structure of the proposed regulations doubtless lie on the legal side and in the need to be prepared for all eventualities. However, the aim should be to structure the regulations so that they are simple as they can be and as legally complex as they need to be.

Sascha Kullig

Sascha Kullig

Association of German Pfandbrief Banks

The vdp has been discussing the introduction of a maturity extension with German regulators and German legislators for years. We have always sought a standardised legal solution in order to avoid divergent contractual regulations and to save investors from having to analyse large numbers of prospectuses. Furthermore, the regulation will apply to both new and outstanding Pfandbriefe, as this is the only way that maturity extensions can fulfil their purpose of reducing short-term liquidity risk on a lasting basis. These two aspects alone require a certain complexity.

The provisions of the Covered Bond Directive on soft bullets have raised the level of complexity still further. The rule that the sequence of the maturities must not change, or more precisely, must not be inverted, represents the biggest challenge. This requirement, coupled with the desirable possibility to repay Pfandbriefe in full or in part between the original and the extended maturity, makes complex legal wording necessary. The only way to structure the text more simply would have been to extend all outstanding Pfandbriefe automatically upon appointment of the cover pool administrator. German legislators did not choose this path, probably in part because constitutional law requires any intervention to be proportionate in relation to Pfandbriefe already in circulation.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

Do you expect the implementation of the Covered Bond Directive to lead to changes to other covered bond laws with regard to soft bullet structures?

Franz Rudolf

Franz Rudolf

UniCredit Bank AG

As I’ve said, soft bullet structures can now be found in almost all countries. However, the regulations are not usually established at legislative level, but instead can be found in the issuers’ documentation and final terms. The implementation of the Covered Bond Directive has now made legal regulation necessary. Only a few countries have published their draft bills to date. We expect this to change in the coming months to ensure compliance with the schedule up to the middle of next year.

In particular, the triggers for a maturity extension – the trigger events Sascha has already mentioned – require special attention. It must be ensured that an extension can be granted only in clearly defined circumstances and that this is not at the issuer’s discretion. This is the only way to ensure that covered bonds receive the best regulatory classification.

Germany is certainly playing a leading role here – both in terms of the timing of publication and with respect to the level of detail.

Sascha Kullig

Sascha Kullig

Association of German Pfandbrief Banks

In our view, three adjustments in particular could become necessary with many soft bullet structures: firstly, incorporation into the respective covered bond law; secondly, clear wording that does not leave issuers with any discretionary leeway; and, thirdly, regulations that preclude the reversal of maturity structures.

As in Germany, the latter requirement in particular could lead to fairly complex regulations in other jurisdictions too. We are curious to see what solutions will be adopted in those countries’ covered bond laws.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

What role will maturity extensions play for investors? Is there a risk that some investors will no longer be able or willing to buy Pfandbriefe because of the introduction of this legislation?

Franz Rudolf

Franz Rudolf

UniCredit Bank AG

Investors have become very familiar with soft bullet structures, which have been gaining ground for years and now account for over half of new issues. With the exception of a few entities whose investment guidelines contain restrictions with regard to covered bonds with soft bullet structures, I don’t anticipate any significant adverse effects. The maximum period of twelve months for a potential extension seems manageable for investors.

In my opinion, it’s important to understand that the maturity extension proposed in the draft bill is ONE additional tool among many available to the cover pool administrator to ensure that Pfandbriefe are serviced in full. Investors appreciate these detailed and forward-looking regulations. Not least for this reason, Pfandbriefe have the lowest risk premiums compared with other markets.

Sascha Kullig

Sascha Kullig

Association of German Pfandbrief Banks

The maturity extension in the German Pfandbrief Act is intended as a last resort. It is meant to be used when the cover pool administrator sees no possible way of redeeming Pfandbriefe at the original maturity date despite all the tools available for generating liquidity in the short term. The issuer is already subject to insolvency proceedings at this point, so we are absolutely not talking about a built-in option for the issuer here. Instead, a maturity extension reduces the risk of a Pfandbrief bank with limited business activities becoming insolvent owing to short-term liquidity shortages.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

Do you anticipate any impact on Pfandbrief spreads and/or ratings?

Franz Rudolf

Franz Rudolf

UniCredit Bank AG

We don’t expect the reforms to have any significant impact on spreads – either negative or positive. With regard to Pfandbrief ratings, initial reactions from rating agencies to maturity extensions indicate that no impact is to be expected here either.

If we look at spread levels for outstanding covered bonds with a soft bullet structure, they do not have higher spreads than comparable hard bullet covered bonds. In my opinion, that is because the probability of a maturity extension is very low overall. Firstly, the Pfandbrief issuer, i.e. the bank, would have to fail, which is unlikely, not least owing to improved capital adequacy in recent years and numerous other measures. If the maturity were nevertheless extended, the maximum period of twelve months is manageable given the normally relatively long tenors of covered bonds and has therefore not been priced in to date. I don’t think it will be any different for German Pfandbriefe.

In view of the more extensive tool box available to cover pool administrators, however, investors might view them even more positively based on risk considerations. At the same time, I think the very low yield levels make further price increases unlikely. In short, we do not expect the introduction of maturity extensions to have any significant impact on spreads. There are other driving forces here, which carry more weight at this particular time.

Sascha Kullig

Sascha Kullig

Association of German Pfandbrief Banks

I haven’t got much to add to that. As we’ve said, soft bullet structures have been a permanent feature of the covered bond market for a long time. Apart from that, the ECB’s massive purchases in particular are leaving their mark on markets. I think a spread reaction due to the introduction of maturity extensions is also unlikely in this market environment.

There could be positive effects on the rating side, as rating agencies regard a maturity extension as an effective tool for addressing short-term liquidity risk. However, the 180-day liquidity buffer is already positively reflected in at least some cases. Overall, we must therefore wait and see whether this will lead to individual rating upgrades or to lower over-collateralisation requirements.