Standard & Poor’s cut Depfa ACS Bank public sector covered bonds by six notches yesterday (Monday), putting them on a par with the issuer’s BBB rating, with the treatment of zero coupon liabilities cited by the rating agency in its action.

S&P said that since putting the covered bonds on review for downgrade on 26 August 2011, it has assessed the issuer’s willingness and ability to manage overcollateralisation at a higher level, but has seen no increase in available OC, even though the credit quality of the cover pool, which comprises mainly European public sector assets, has deteriorated. The covered bonds were cut from AA.

“We are lowering our ratings on Depfa ACS Bank’s public sector covered bond programmes and related issuances and removing them from CreditWatch to reflect our opinion of the increasing credit risk of the cover pool assets,” said S&P, “and the fact that, in our view, the issuer is not managing overcollateralisation to a level that we consider to be commensurate with an uplift above the issuer credit rating on the bank.”

The rating agency assigns the programme to Category 2 under its framework, with an asset-liability mismatch (ALMM) risk of “low”. This means that it could achieve a maximum uplift of six notches above its issuer rating for its covered bonds.

S&P has determined that credit enhancement of 11.67% would currently be necessary to achieve this, with 6.36% being necessary for a one notch uplift.

However, according to S&P, available OC was found to be only 1.74% as of 29 February, meaning that it is not assigning any notches of uplift.

S&P acknowledged that the OC ratios it has calculated differ from those the issuer has published and that this is the result of the “different presentation” of zero coupon liabilities.

“Data published by the issuer is based on zero coupon bonds presented at their current notional amount, as per legal reporting requirements,” said the rating agency. “In our publications we present zero-coupon bonds at their final redemption amount, consistently for all issuers.”

S&P noted that using Depfa ACS Bank’s convention, available credit enhancement as of 29 February was 8.81%.

But S&P said that since its calculation of target credit enhancement levels is based on asset and liability cashflows, and not on initial nominal balances, the difference in OC ratios is “presentational only”.

“Based on the issuer’s presentation of overcollateralization ratios, the credit enhancement level commensurate with the first notch of uplift would be 13.75% and the credit enhancement commensurate with the maximum achievable rating would be 19.43%,” said S&P. “This presentational difference has increased over time as cash-pay issuances have been redeemed, leaving zero coupon bonds as an increasing portion of outstanding liabilities.”

A covered bond analyst noted that Moody’s rates Depfa ACS covered bonds Aa3 and Fitch AAA on Rating Watch negative.

“The Fitch database shows an 8.7% OC requirement as 31 December 2011, i.e. assuming that Fitch is fine with the ‘current notional value’ calculation, rating downside risk is limited,” he said. “The Fitch probability of default rating regarding Depfa ACS Bank covered bonds was AA (as of December 2011).”

He also noted that Depfa ACS Bank has a committed OC level of 5%.