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Introduction

 

Eight years have passed since the European Banking Authority (EBA) noted the need for convergence of covered bond frameworks in the European Union (EU), to strengthen the covered bond market and ultimately provide financial stability. The ensuing principle-based Covered Bond Directive (CBD) was approved and published five years later in 2019, after long discussions and hard negotiations among European authorities, in an attempt to harmonise the national legislations of 27 EU member states, whilst accommodating sometimes contrasting markets needs and practices. The journey came to a successful end in 2022, the first year to see the new CBD transposed and in force in each and all national legislations.

 

The principle-based approach meant focusing on what was deemed as fundamental to the concept of covered bonds, while allowing for specificities of each of the existing national markets. Or, in other words, enhancing comparability, transparency and global recognition, while ensuring continuity of well-functioning domestic markets with which investors developed familiarity over the years.

 

In concrete, while dual-recourse, asset segregation, bankruptcy remoteness, public supervision, and the existence of a liquidity buffer, are examples of principles deemed as fundamental to be preserved and adopted, and were thus embedded in the CBD, elements such as maturity extension triggers, liquidity buffers, over-collateralisation (OC) and labelling, were thought to be best left to member states to specifically decide upon. Some of these country-specific elements have therefore been implemented with slight differences, which this chapter will analyse. It will also have a look at how the transition has played out in the primary and secondary covered bond markets.

 

Triggers for Extendable Maturities

 

As part of the harmonisation effort, the CBD introduced for the first time in European-wide legislation the concept of extendable maturities, and in particular the need to harmonise the various extension options many covered bond programmes had contractually introduced. To assure investor protection, art.17 of the CBD clearly outlines the requirements issuers need to meet to be able to issue covered bonds with extendable maturities. Namely, the CBD requires Member States to include objective triggers specified in national law, and not at the discretion of the issuer, as conditions for covered bonds to extend.

 

Looking at how the extension features have been transposed into national covered bond frameworks, we can group the triggers into two main groups: (i) countries where the extension is a tool available for the covered pool administrator to avoid, or delay, the insolvency of the issuing entity, and (ii) countries where the extension can occur, or be decided upon, prior to the insolvency of the issuing bank, and will be triggered simply via non-payment of principal or interest on the covered bonds, even if still subject to conditions. It is not surprising that each Member State has identified slightly different triggers; finding one solution fits all would have been arduous mainly due to the fact that across Member States we have at least three covered bond issuance models: ring-fencing on balance sheet, specialist banking model and SPV guarantor structure.

 

Liquidity Buffer

 

Linked to the maturity extension triggers is the calculation of the liquidity buffer while art.16 comma 2 of the CBD prescribes how the liquidity buffer should be calculated stating that the cover pool liquidity buffer shall cover the maximum cumulative net liquidity outflow over the next 180 days, discretion was left to the national regulators to assess if the expected or the extended maturity date should be considered when including principal payments in the programme outflows. We focused our analysis on the top 12 Member States by covered bond issuance volumes and can report that only 2 countries being Germany and Denmark include covered bond principal payments as outflows at all times in the liquidity buffer calculation while the other ten all allow issuers to calculate the liquidity buffer using the extended maturity date in case of soft bullet or conditional pass-through covered bonds.

 

Minimum Overcollateralization

 

Another requirement that was left to transpose at the national regulators’ discretion was the minimum overcollateralization amount. Regulation (EU) 2019/2160 allows national regulators to set the minimum level of overcollateralization between 2% and 5%. Our analysis shows that various Member States have introduced distinct levels of overcollateralization for different types of cover pool assets, for example in Germany, the nominal overcollateralization required is 2% if the cover pool assets are either mortgages or public sector assets while for shipping and aircraft cover pools the overcollateralization requirement in 5%. Focusing on cover pools backed by residential mortgages, out of the 12 jurisdictions assessed, Denmark, Germany, Sweden, Austria and Finland have transposed a 2% minimum overcollateralization amount while for the remaining seven (ie France, Spain, Netherlands, Italy, Norway, Belgium and Portugal) require a 5% overcollateralization amount. It is interesting to see how in some jurisdictions the statutory overcollateralization is higher than what the rating agencies require to assign the rating to the covered bond.

 

Labelling

 

Finally, when looking at how each Member State has transposed the labelling requirement (art.27 CBD) it is clear that each national regulator has focused on giving the ability to their issuers to issue European Covered Bonds (Premium) with European Covered Bonds being issued only if the issuances do not comply with the requirements of the CDB or the national frameworks. Of the 12 Member States analysed none seem to have transposed the ability to issue European Covered Bonds backed by assets such as auto loans or public undertakings. Finally, we have seen divergence amongst Member States on how grandfathered covered bonds should be labelled, there are some jurisdictions like Spain and Belgium where once the covered bond programmes have been updated to become CBD and CRR compliant, all covered bonds issued from the programme pre or post 8 July 2022 have been/can be labelled as European Covered Bond (Premium) while in most other jurisdictions only covered bonds issued post the update of the programme to comply with the new covered bond package can benefit from the European Covered Bond (Premium) label.

 

 

 

HOW THE CBD IS SHAPING THE MARKET

 

The sections that follow give an overview of the some of the changes introduced via the CBD and how they are shaping the covered bond market.

 

Soft bullet dominant structure

 

One of the key features of the new CBD was the inclusion of conditions for extendable maturity structures. This was likely due to the emergence of covered bonds with extendable maturities, either in soft bullet or conditional pass-through (CPT) format, over the past years. Indeed, already back in 2017, 49% of euro benchmark covered bonds in the iBoxx index had a soft bullet structure, while 1.8% had a CPT structure, leaving 49% of traditional hard bullet covered bonds. In June 2023, only 19% of hard bullet covered bonds remained in the iBoxx euro covered bond index, while 78% of the bonds in the index were soft bullets and 2.7% CPT covered bonds. So, the transposition of the CBD into national covered bond laws has resulted in a further rise in the share of covered bonds with extendable maturities, with the switch of German Pfandbriefe from hard to soft bullets already having a big impact (as their share in the index is almost 20%).

 

A breakdown of outstanding covered bonds by maturity type and country shows that only Luxembourg has only hard bullet covered bonds outstanding (but only one bond as well), while in Spain and South Korea around 65% of outstanding covered bonds are still in hard bullet format. Austria, Denmark, and France are also jurisdictions where around 40-45% of outstanding euro benchmark covered bonds are hard bullets. But roughly half of the jurisdictions that are included in the index have only soft bullet covered bonds outstanding, while some have a combination of soft bullet and CPT covered bonds. Interesting in this respect are the Netherlands, where in 2013 the first CPT covered bond was issued. However, all the issuers that initially opted for this structure have now switched to soft bullet covered bonds. This will reduce the amount of outstanding CPT covered bonds over time. Moreover, some of the Dutch issuers have asked investor consent to change their CPT covered bond to soft bullets (NN Bank and Achmea Bank), having terminated their CPT covered bond programmes.

 

As said, the CBD has stimulated more and more countries to embrace the maturity extension structure when transposing the CBD into national law. As a result, soft bullet covered bonds will further enlarge their footprint, with CPT covered bonds slowly disappearing. This was clearly visible in the issuance data. Only looking at last year’s issuance of euro benchmark covered bonds from issuers located in the euro area, 85% of the total volume of new supply were soft bullet covered bonds. Furthermore, these were also issued from a range of euro area countries. After 8 July 2022 (the date that the CBD became effective), the share of soft bullet covered bonds in total issuance rose to 92%, while that of hard bullet covered bonds dropped to just below 8% (was 15% in January-June period). Moreover, the hard bullet covered bonds were only issued by French issuers that have been committed to hard bullet covered bonds.

 

 

Taking into account euro benchmark issuance of all jurisdictions in 2022, 90.4% of the volume of new issuance of euro benchmark covered bonds were soft bullet covered bonds, 9.3% were hard bullets, and 0.3% were CPT covered bonds. This compares to shares of 62.6%, 33.9%, and 3.4% in 2017, respectively. This year (2023), the share of soft bullets rose further to 92%, while that of hard bullets was 8% (implying no CPT covered bond issuance so far in 2023). Only French, Slovakian, and Korean issuers came to the market with hard bullet covered bonds. This clearly illustrates the dominance of covered bonds with a maturity extension, and especially soft bullet covered bonds, which in fact have become (and will remain) the standard format for covered bonds.

 

Smooth transition to Premium Label

 

The transposition of the new CBD in national laws was a lengthy process. Regulators in some countries only released all details of the updated covered bond framework just ahead of the CBD becoming effective as of 8 July 2022, while in some other countries the details were published even months after the deadline passed. Still, the transition to the new regime has gone smoothly. Under the new regime, covered bonds that comply with the CBD as well as with the update Capital Requirements Regulation (CRR) Article 129 can be labelled ‘European Covered Bond (Premium)’, benefitting from favourable regulatory treatment (Generic Section, Chapter 2). The first Premium-labelled euro benchmark covered bond was issued on 18 July 2022 by German bank LBBW and the covered bond market has welcomed many more since then, with the first Portuguese and Italian Premium covered bonds arriving in April and June 2023. Almost all euro benchmark covered bonds that were issued after 8 July 2022 have the Premium label, while in some countries also covered bonds issued before 8 July 2022 have been labelled Premium following an update of the issuers’ covered bond programmes. As such, a large portion of the index already consists of Premium-labelled covered bonds.

 

The transition has also gone unnoticed with regards to the pricing of covered bonds in the primary and secondary markets. Indeed, there was no material difference observable between new issue premiums and demand for Premium covered bonds and covered bonds issued before 8 July that benefitted from similar regulatory benefits (i.e., those that complied with the UCITS Directive 52(4) as well as the CRR). This underlines the strength of the asset class (also already before the CBD became effective) and the confidence investors have in the product. With the majority of covered bonds now being in extendable maturity format, it also shows that the vast majority of investors is comfortable with investing in covered bonds with maturity extension features.

 

Conclusion

 

In a political union of 27-countries where, depending on which, the history of covered bond ranges from just over a decade to more than 250 years, the idea of harmonising domestic legislations, market practices, and even conceptualisations of what a covered bond is, or ought to be, was often seen as an overly ambitious project, possible only in the minds of Brussel bureaucrats. Quite the contrary ended up being the case.

 

The strategy designed and adopted – starting with the choice of a principle-based approach, followed by deep involvement of the industry, their market players and experts, whose voice the ECBC takes to the European authorities through its members and the analytical work of dedicated teams, a constant presence throughout the multi-year legislative process – showed as much commitment with the initial objectives as an impressive market sense and pragmatism.

 

Now that the initial objectives have come to fruition, with the CBD fully transposed into each and all of the EU member states and, not least, being chosen as blueprint for covered bond legislations elsewhere, one point became clear: a close working relationship between market players, authorities, and regulators in equal measure, proved to be a fundamental ingredient of the secret sauce flavouring constructive, supportive and effective European-wide capital market legislation.

 

 

By Elena Bortolotti, Chairwoman of the RAA WG & Barclays, Joost Beaumont, ABN AMRO, and Claudio Domingues, Millennium bcp