Harsher ECB haircuts for maturity extendible covered bonds used as repo collateral announced yesterday (Thursday), which hit CPTs hardest, are not expected to prompt a dramatic change of heart on their use, even if the central bank’s stance is contentious.

The European Central Bank announced in November 2016 that it planned to adjust the haircuts it applies to retained soft bullet and CPT covered bonds in its collateral framework to reflect “additional risks”. The new rules, which had originally been due by the end of 2017, arrived yesterday.

Among amendments to Article 3 of Guideline (EU) 2016/65 (ECB/2015/35), the ECB states that for covered bonds, among other marketable assets, the applicable valuation haircut will now depend on the residual maturity, defined as the maximum legal maturity – having formerly focussed on the expected maturity – and coupon structure of the bond.

This means that a five year soft bullet covered bond with the possibility of a one year maturity extension will be treated as having a residual maturity of six years – meaning it will fall into the 5-7 year haircut bucket – while a five year conditional pass-through (CPT) covered bond that can be extended by 30 years will be treated as having a residual maturity of 35 years – meaning it will fall into the most costly, 10 year-plus maturity bucket. This could result in a doubling of haircuts for some CPTs.

“This approach therefore favours the use of retained soft bullet covered bonds over CPT covered bonds for ECB collateral purposes, and hard bullet over soft bullet structures for bonds with an intended maturity date up to nine years,” said Maureen Schuller, head of financials research at ING.

UCITS-compliant “jumbo” covered bonds are included in haircut category II and other covered bonds in haircut category III.

The ECB is also introducing haircuts for assets with floating rate coupons. Under previous rules, floating rate covered bonds of any maturity that had a variable coupon were categorised in the most favourable haircut bucket applicable to fixed coupon bonds with a 0-1 year maturity.

“Retained covered bonds, for that reason, commonly have floating coupon structures,” said Schuller. “The haircut granularity remains nevertheless more favourable for variable coupon than for fixed coupon bonds.

“As a matter of fact, up to a five year maturity nothing changes in the sense that the haircut of a variable coupon bond remains the same as for a 0-1 year fixed coupon bond. Hence, variable coupon structures are expected to remain the preferred choice for own-use purposes.”

Own-use covered bonds are still subject to an additional haircut introduced in November 2015, of 8% for covered bonds in Credit Quality Step 1 & 2, and 12% for covered bonds in Credit Quality Step 3, which will be applied on top of the haircuts announced yesterday.

The changes were broadly in line with expectations, although an analyst said the result could have been worse for extendible maturity covered bonds, with discussions within the ECB said to have included the possibility of even harsher treatment.

Many market participants have objected to the ECB’s stance towards CPTs, adjudging it overly harsh and unfair on those who might benefit most from the instrument.

“I understand that the ECB don’t like maturity extensions being used for rating arbitrage,” said one, “but if you look at what banks need most help, then it is indeed the weaker banks most inclined to use these structures in that way.

“It is a short-sighted view, in my opinion.”

Analysts and market participants said the impact of the new rules will vary between jurisdictions.

In the Netherlands, for example, where the CPT structure was pioneered, no issuer uses covered bonds of any maturity structure for ECB repo purposes – although ABN Amro set up a soft bullet programme for retained issuance last year.

Bankers noted, however, that CPT structures are prevalent in some peripheral markets, suggesting such issuers could be harder hit.

Soft bullet covered bonds are deemed to have gotten off relatively lightly, with market participants noting that for a seven year soft bullet covered bond, for example, the haircut remains the same.

“Given that most soft-bullet covered bonds have an extendible maturity of 12 months, and the ECB valuation haircuts are set out in maturity buckets … we do not believe the changes in repo haircut for retained soft bullet covered bonds will have much of an impact,” said Cristina Costa, senior covered bond analyst at SG.

Valuation haircut levels applied to eligible marketable assets in haircut categories II & III including covered bonds

Note: Bold indicates new haircut scheme for marketable assets; normal font means no change vs previous haircut scheme of November 2016; Residual maturity buckets as follows: (0-1): residual maturity less than one year; (1-3): residual maturity equal to or greater than one year and less than three years; etc. Source: ECB, SG, The CBR

However, the action is seen as more damaging to the attractiveness of CPT covered bonds, coming after other policy moves from the ECB that signal a negative attitude towards the structure. As of 1 February, for example, covered bonds that have a CPT structure and are issued by an entity with a first-best issuer rating below CQS3 became ineligible for purchase under the ECB’s third covered bond purchase programme (CBPP3) – affecting four peripheral programmes.

That announcement prompted Greek issuer Alpha Bank to convert its CPT covered bond programme to a soft bullet format, before it issued an inaugural benchmark on 25 January.

“The message from the ECB has been clear,” said a banker close to Alpha’s deal, “they do not like this structure.”

Bankers said the attractiveness of using covered bonds or the alternative of RMBS as collateral under the new regime will vary from issuer to issuer.

“It’s very specific to the issuer,” said a banker who works in origination. “RMBS haircuts depend on the expected weighted average life of the underlying portfolio, and they don’t give credit to the issuer’s call option.

“So if you’re an issuer and you have a portfolio of mortgages and you’re wondering whether to use them in RMBS or covered bonds for ECB repo, it depends on the particular pool, because the haircuts for RMBS are still higher than for covereds.”

He added that the decision would also rest on an issuer’s willingness to go through the cost and effort of setting up new programmes or moving collateral.

“I don’t think issuers will go through the effort of setting up a whole new programme to take advantage an incremental benefit,” he said. “It’s the kind of thing an issuer will come around to if they have to renew a programme or reissue a security – you’re not going to wake up tomorrow and think ‘I have to set up an RMBS programme’.”

The ECB meanwhile announced that it would no longer accept CMBS as collateral, with the ECB stating that their risks and complexity are substantially different from other ABS.

The new rules must by applied by Eurozone central banks from 16 April.