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The devil is in the cliché (4): Extension triggers

15 May 2019
Richard Kemmish

The covered bond directive has a surprisingly large number of paragraphs that make normal people question the intent. The definition of the conditions to trigger an extendable maturity are clearly a political compromise. That’s the wrong starting point.

I get it. Lots of people really don’t like maturity extension triggers in covered bonds. Some – mentioning no names – even proposed that extendables have a higher risk weighting than ‘hard bullets’. The final text of the directive avoids that in return for some ‘concessions’ about how the extensions can be triggered.  There are some concerns about extensions that stem from ignorance of the structure, and some that are valid.

Let’s look at the valid ones. 

The most commonly cited concern about extensions is partly valid in slightly less than half of the bonds currently outstanding: that it is a free option to extend. This is the one that this article tries to address. An extension of a maturity which can occur without a failure of the issuer is a potential life-line to a bank struggling to roll its debt but yes, that is putting the interests of the bank ahead the interests of the covered bond holders.

To prevent a free option, according to the new directive extensions have to be with reference to ‘objective triggers established in national law’. But if the government wants the banks to have this free option – for example to provide that lifeline and benefit systemic stability at the expense of bond holders – then they still can, they just need to define the right ‘objective triggers’. Given the objections raised by national lobbies to the original wording of this article I think it’s safe to say that they will find ways to legislate the free option back into existence.  

For me the biggest valid concern with extendables is that, by being more efficient they allow lower o/c levels than hard bullet programmes, ceteris parabus. Oddly the directive doesn’t countenance this concern. It wouldn’t have been too difficult to address this – a principle based requirement that the supervisor takes this into account in stress tests for example. But silence.  

The final objection that I consider valid is the greater complexity of structures and triggers in extendable structures. By requiring that investors have sufficient information “to determine the risk”, the directive tries to address this concern. But structural heterogeneity can only be addressed by voluntary means – such as a market led initiative towards a standard model and/or a simplified disclosure of structures (ever tried understanding the differences between two conditional pass throughs by reading the offering circular? I do this stuff for a living and I struggle with it).    

One very small, final, objection: the requirement that the final maturity date of the bond can at all times be determined could be understood to refer to the de facto maturity date (which will depend on when the assets can be sold or refinanced) rather than the legal final maturity date (which will remain the same before and after a trigger. 

The directive does require a lot of laws and/or programmes to be amended. For example, the requirement that the terms are in both the ‘national law’ (paragraph 1(a)) and the ‘contractual terms and conditions’ (paragraph 1(b)) means that more or less everyone has to change something.

It should also start an industry debate on standardisation, disclosure and what exactly ‘objective triggers’ actually means. If it does that, it will be helpful.


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