Increased issuance of covered bonds and renewed repo activity driven by high levels of investor risk aversion to senior unsecured debt raises asset encumbrance issues, said Fitch in a report yesterday (Thursday), but the rating agency sees the trend easing, even if bank funding costs remain elevated.

Fitch said that the heavy reliance on secured funding, and the negative consequences thereof, could fall when the economy recovers more broadly and risk aversion declines.

“Investor risk aversion toward the banking sector, and unsecured bank debt in particular, has increased for both cyclical and structural reasons,” said Gerry Rawcliffe, managing director in Fitch’s financial institutions team. “This will be partially mitigated as economic factors improve, but we continue to expect lower support from governments, which will impact investor appetite for the sector.”

Fitch blamed limited transparency of banks’ exposures to troubled counterparties and toxic assets for increasing market risk aversion during the crisis, and identified a general cyclical increase in risk aversion since the crisis.

Lower rated banks have issued more covered bonds in light of “soaring” refinancing costs, noted the rating agency, while higher rated banks used senior unsecured funding throughout the crisis and covered bonds to access cheap funding from central banks.

But the greater use of covered bonds, which has evolved out of regulatory reforms and other measures pushing the asset class to the fore, will hit a peak, said Fitch.

“Fitch believes that the limited supply of high quality cover pool assets and national regulatory limits, if properly monitored and enforced, serve as checks to the use of covered bonds, allaying some investor concerns over high issuance volumes in recent months,” it said.

The rating agency said that it would continue to monitor the level of secured liabilities in a bank’s funding mix.

“Fitch believes that a high dependence on secured sources of financing such as asset-backed securitisations, repurchase agreements, covered bonds or secured bank loans could constrain ratings,” it said. “Fitch also believes that an over-reliance on secured financing could encumber most assets on the company’s balance sheet, reducing overall financial flexibility.

“In addition, a high concentration of secured financing increases the risk that unsecured creditors could be adversely affected as secured creditors may have priority claims to higher-quality assets. If the industry shifts to a significantly higher level of secured funding versus historical levels, Issuer Default Ratings (IDRs) could come under pressure and unsecured debt ratings could fall below the IDR due to lower recovery expectations.”

Fitch nevertheless noted the benefits covered bonds can carry for issuers from a ratings perspective.

“Most global trading banks did not have a covered bond programme prior to the crisis, but many have established such programmes in the past two years,” it said. “As such, the use of covered bonds by these banks remains limited, but represents a funding source offering potential diversification and maturity extension benefits. This potential has yet to be fully tapped by these banks.”