Deteriorating issuer credit quality and a weakening of sovereigns are the key threats to covered bond credit quality in 2012, according to Moody’s, although regulatory developments are set to support demand for the asset class.

Of the covered bond programmes in Europe that Moody’s rates, 69% are backed by issuers on review for downgrade or with a negative outlook, “largely mirroring the outlooks of the banking sectors and sovereigns where those issuers are based”.

The Timely Payment Indicator (TPI) leeways for covered bond programmes are expected to deteriorate in 2012. TPI limits are increasingly likely to be breached and covered bond downgrades will generally follow if TPIs are lowered and/or issuer credit quality deteriorates.

Jane Soldera, Moody's

Peripheral issuers will be most at risk in 2012, said Moody’s, particularly those in Spain and Italy – countries that were downgraded in October. The rating agency said further deterioration of the sovereigns’ credit quality would be negative for the quality of covered bond programmes in these countries.

Issuers in stronger countries are also expected to experience deteriorating credit quality.

“Banking systems in stronger countries such as Germany and the UK face significant challenges in an environment of eroding investor confidence,” said Moody’s.

Banks elsewhere in Europe face significant challenges, too, added the rating agency, including direct exposures to the peripheral euro-zone, a more difficult operating environment created by the crisis, and increased regulation and reduced government support in their own countries.

Other covered bond programmes in weaker countries, such as Ireland, Portugal, and Greece, “have suffered material weakening in their credit quality already, so, in the absence of a severe shock, may be relatively stable in 2012”, said Moody’s.

Bail-in rules proposing creditor burden-sharing, which are likely to exclude covered bonds, are likely to increase demand for covered bonds, said the rating agency. It said bail-ins should promote a deeper and more liquid market for covered bonds, which should help to mitigate refinancing risk.

“Regulatory changes at the national and pan-European levels continue to improve safeguards and increase transparency for covered bond investors and these improvements will continue,” said Jane Soldera, vice president and senior credit officer in Moody’s structured finance group.

The rating agency said as negative sovereign and banking sector outlooks continue to feed through to deteriorating issuer credit quality there will be a continuing reliance on repo funding, particularly in peripheral Europe.

Programme restructuring may occur in weaker countries, said Moody’s, in an attempt to remove or mitigate refinancing risk, for example, by issuing bonds with long extension periods.