Moody’s highlights lower fire-sale risk from SCBC soft bullet

Oct 10th, 2014

Moody’s noted that the soft bullet mechanism used by SCBC for the first time on a Eu1bn covered bond launched on Tuesday of last week (30 September) reduces fire-sale risk associated with covered bonds in the event of default, which is the major driver of cover pool losses.

SBABinstagramThe Swedish Covered Bond Corporation (SCBC) deal is understood to be the first time a soft bullet has been used by a Swedish issuer, although the structure is widely used in many other jurisdictions, with Moody’s noting that it is an accepted market norm in neighbouring Norway, for example.

In SCBC’s case, the soft bullet structure implies an automatic extension of the bond’s maturity date by a maximum 12 months if the bonds are not repaid in full on the initial maturity date, according to Moody’s.

“We expect that the soft bullet bonds will — while the issuer is not insolvent — be repaid by the issuer at the initial maturity date,” the rating agency said. “However, in periods of severe stress the maturity extension helps to reduce fire-sale risk as it allows additional time to raise alternative financing or to liquidate the cover pool assets in a more orderly manner, thereby avoiding a high discount.

“This gives the issuer additional flexibility also in a pre-insolvency situation. Fire-sale risk exists when cash collected from the cover pool assets is insufficient to make timely payments on the covered bonds after the issuer has become insolvent.”

Moody’s said that fire-sale risk is the major driver of cover pool losses in most covered bonds, including SCBC’s. For SCBC’s programme, the Maximum Mismatch — which is the rating agency’s measure of the portion of the cover pool subject to fire-sale risk — is 64%, compared with a European average of around 43% and around 60% for Swedish programmes. Moody’ said that fire-sale risk is currently “significant” as the weighted average life of SCBC’s cover pool assets is 22.8 years, compared with 2.8 years for the covered bonds.

Moody’s said that as the Eu1bn issue accounts for just 6.2% of SCBC’s outstanding covered bonds it will affect the rating agency’s assessment of fire-sale risk “only marginally”.

“If SCBC were to issue only soft bullets in future, the share of hard bullet covered bonds would decrease over time,” it added. “However, a significant risk of a fire sale remains in structures in which not all series are soft bullet.”

The rating agency said it reflects reduced fire-sale risk for those issuers that issue only soft bullets in two steps of its methodology: through its expected loss analysis, requiring lower OC consistent with the lower current Aaa rating; and a possibly higher Timely Payment Indicator (TPI), reflecting a higher probability of timely payments in the event an issuer is unable to make payments on the covered bonds.

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