Many of S&P’s covered bond ratings would be resilient to moderate stress in the shape of one to two notch issuer downgrades, the rating agency said today (Tuesday) after conducting a scenario analysis. It said that this is partly due to overcollateralisation demands resulting from a change to its methodology in 2009.

Deteriorating creditworthiness of many banking systems has focussed attention on the link between bank ratings and covered bond ratings, said the rating agency in a report, adding that a covered bond rating’s robustness to deteriorating issuer creditworthiness can be measured by the number of unused potential ratings uplift under its covered bond rating methodology.

This is captured by the difference between the maximum potential number of notches a covered bond programme can be rated above the corresponding issuer rating, and the actual number of rating notches uplift from the issuer credit rating (ICR).

Andrew South, senior director, structured finance at S&P, said that the unused notches can be viewed as a cushion.

In addition to looking into the availability of unused potential ratings uplift based on a sample of 87 programmes, S&P carried out an analysis to investigate the overall sensitivity of its sample of programmes to underlying issuer downgrades.

This was on the assumption that the asset-liability mismatch (ALMM) risk that helps determine the maximum potential uplift between the ICR and a covered bond rating does not change, with the analysis also leaving aside country risk, which could additionally constrain how high S&P rates a covered bond programme.

The scenario analysis shows that in the event of a uniform one notch lowering of all respective issuer ratings only 23% of programmes in the sample, by number, would likely have their ratings downgraded, and that the average change in credit quality would be a lowering of 0.23 notches.

Assuming issuer downgrades of two to three notches 41% and 66% of covered bond programmes, respectively, would be cut, the rating agency said.

However, S&P said that the majority of programmes would remain rated double-A or triple-A even under the “relatively substantial scenarios” of issuer downgrades of up to three notches.

“For example, we currently rate 86% of programmes in our sample AAA,” it said in today’s report. “If we downgraded all of the underlying issuer ratings by one notch, 76% of the programmes would remain rated AAA, with a further 17% rated in the AA rating category.”

If all of the underlying issuer ratings were cut by three notches, 87% of the programmes in the sample would remain rated in the triple-A and double-A rating categories, it added, of which 33% of the programmes would remain rated triple-A, with a further 54% rated double-A.

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Sabrina Miehs, director, covered bond ratings at S&P, said that in the rating agency’s view the analysis shows that its covered bond ratings react only very marginally to a moderate hypothetical stress of a one to two notch issuer downgrade.

“With 76% of the triple-A rated programmes in the sample keeping the top rating, we can say that the majority of covered bond programmes would not be affected by issuer downgrades of one notch,” she said.

“The other key message for us is that even if you assume more substantial issuer downgrades the majority of covered bond programmes would still be double-A or triple-A rated, which we still find a very good rating,” she adds. “The difference between the probability of default between a double-A rated covered bond and a triple-A rated covered bond is quite marginal.”

South said that the scenario analysis does not take into account the scope that issuers have to manage their programmes to lower asset liability mismatch risk.

“There is still some room for resilience that could offset issuer downgrades,” he said.

S&P’s report said that a reduction of ALMM risk so that a programme is classified one category better would increase by one notch the maximum potential number of uplift from an ICR, which would reduce the number of covered bond programmes whose ratings would be cut in a hypothetical case of an issuer downgrade.

The proportion of programmes downgraded would fall from 23% to 13%, from 41% to 33%, and from 66% to 64%, respectively, under the one, two, and three notch issuer downgrade scenarios mentioned above.

However, most covered bond programmes rated by S&P are already classified as having low ALMM risk, said Miehs.

S&P said that the ratings stability revealed by its scenario analysis is partly due to the rating agency only rating programmes triple-A if they are highly overcollateralised, regardless of how highly it rates the issuer.

Miehs said that this was a decision taken when the rating agency switched to its new covered bond rating criteria in 2009.

“It was very important for us not to include any benefit from the issuer rating in the calculation of target overcollateralisation levels,” she said. “Our criteria are set up to size the level of overcollateralisation to address the risks in covered bonds from day one, without a link to the issuer credit rating, so that when an issuer rating is lowered the target level of OC does not change.”

This approach avoids putting additional financial stress on the issuer, she added, which would otherwise find itself needing to increase overcollateralisation to maintain the covered bond rating.

In its report S&P said that this contrasts with the approach of some other rating agencies, which it said may assign their highest rating to a covered bond programme with less overcollateralisation on the basis that the issuer’s credit rating is relatively high.

“However, if the ICR later falls, then the minimum level of overcollateralisation commensurate with the highest covered bond rating could increase,” said S&P. “As a result, the covered bond ratings may only remain stable if the issuer increases the programme’s overcollateralisation. Adding more collateral to the cover pool may be challenging in a financially stressed environment.”