German building societies have been prohibited from buying soft bullet covered bonds, it emerged at an AFME/vdp conference on Friday, while market participants expressed frustration at the challenges of engaging with the ECB on similar topics and questioned whether CPTs could widen.

Some financial and regulatory bodies, notably the European Central Bank, have discriminated against soft bullet and conditional pass-through (CPT) covered bonds, despite such structures becoming increasingly prevalent and apparently accepted, with pricing differentials between them and hard bullets diminishing. Most recently, the ECB two weeks ago said that from February CPT covered bonds of sub-investment grade issuers will no longer be eligible for CBPP3.

At an AFME/vdp (Association for Financial Markets Europe/Association of German Pfandbrief Banks) event in Berlin on Friday, a delegate from the buyside in the audience said – to the surprise of panellists including European Commission and vdp representatives – that BaFin has recently prohibited Bausparkassen (German building societies whose activities are already limited) from buying soft bullets.

A BaFin spokesperson confirmed the stance to The CBR, explaining:

“According to German law, Bausparkassen are subject to certain restrictions regarding their capital investments. Thus, covered bonds with derivative components are generally not considered to be an eligible investment for Bausparkassen. As an exception to the rule, BaFin accepts bonds with certain ‘clean-up call options’ due to their importance at the market. In case of the mentioned soft bullet covered bonds, however, the ‘clean-up call option’ poses a significant liquidity risk. As a consequence, Bausparkassen are not allowed to invest in such bonds.”

The buyside delegate told The CBR that a Bausparkasse client had informed her of the policy. She suggested that whereas BaFin does not have a problem with calls that result in the repayment of a bond before maturity (and banning such bonds would substantially reduce Bausparkassen’s investment opportunities), the German supervisor sees liquidity risks with respect to soft bullets because of the potential maturity extension.

She said the policy may be based on a view that the ban would not significantly diminish the investment opportunities of Bausparkassen. However, according to recent figures from DZ Bank analysts, some 60% of benchmark covered bonds issued this year are soft bullets and 3% CPTs, and only 36% hard bullets, with hard bullets having been in the minority for the previous three years, too. Another delegate suggested that if Bausparkassen are prohibited from buying soft bullets, they are surely not allowed to buy CPTs.

Contrary to most jurisdictions today, Germany’s Pfandbrief market remains hard bullet-only. The vdp last year proposed an amendment to the Pfandbrief Act that would allow some standard and legislated extension in certain circumstances, but the association is understood to have put any such plans on hold, with a lack of progress with regulatory authorities and subsequent political deadlock cited as factors in this.

Meanwhile, Ralf Grossmann, head of covered bond origination at Société Générale and incoming European Covered Bond Council deputy chairman, highlighted from the floor how – in spite of encouraging work by the Commission – there are some “concerns” and “threats” to the covered bond market, “first of all from the ECB, and second from the Basel Committee”.

“The ECB is publishing from time to time some decisions which, for the last two we have seen, were not really in favour of treatment of covered bonds,” he said. “How should we address this going forward?”

Jens Tolckmitt, vdp chief executive, agreed that the ECB situation is “difficult”, saying it is “quite regularly hard work convincing them to actually enter into a dialogue with the industry before they issue a statement, and not afterward”.

“I think that’s simply a challenge for everybody,” he added.

A credit analyst at a bank investor said that – while maturity extension considerations might be prime for LCRs, for example – the ECB’s exclusion of sub-investment grade CPT covered bonds from CBPP3 is hard to fathom, given that it does not face similarly tight constraints.

“Where is the risk for a central bank investing in CPTs?” he asked. “There is not additional risk for them. A CPT is effectively hurting somebody who is extremely sensitive to postpone a payment – which is not the ECB.

“The first reaction I had on that piece of news was that you are effectively as the ECB hurting the ones that require most support,” he added. “Why would you do that?”

He suggested that the announcement could be a “test balloon” and that, as an analyst, he will be closely watching any spread reaction of CPTs in the coming weeks, saying: “Are they going to widen? How much are they going to widen?”

Didier Millerot, head of unit, banks and financial conglomerates, DG FISMA, said that CPTs are just one topic the Commission is trying to strike the right balance on in its planned EU framework for covered bonds, but that it is not trying to make them “impossible to use”.

However, although market participants have been encouraged by the Commission’s evolving thinking on CPTs, some have noted that even if the Directive encompasses CPTs and soft bullets that meet certain minimum standards, the ECB, regulators and supervisors in member states will still be able to discriminate against them in their respective areas of responsibility.

Photo: BaFin, Bonn