Downgrades of covered bonds to below triple-A are likely to fall in significance for insurance company investors as a result of recalibrated capital charges under the latest EC Solvency II proposal, according to an analyst, as the required spread pick-ups for double-A covered bonds shrink considerably.

As reported in The Covered Bond Report in December (here) and noted by Fitch on Monday, the latest draft rules proposed by the European Commission extend favourable treatment to covered bonds by allocating double-A rated covered bonds to a separate category of lower capital charges (0.9% compared with 1.1%) and softening the linearity between duration and capital charges after five years.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB, said that the double-A rated covered bond sector would benefit significantly from these proposals.

“The covered bonds rating cliff with the biggest capital impact for insurance companies is now between AA- and A+, which is also the relevant cliff in the CRD IV,” he said.

The capital charge for double-A rated covered bonds, especially for longer dated maturities, drops considerably, he said, with a 0.9% capital charge the starting point rather than 1.1% as was the case under an earlier proposal, and subsequent increases after year five are significantly smaller, with the capital charge for a 10 year double-A rated covered bond about 4% less, at 7%.

He noted that the capital charge for triple-A rated covered bonds has increased slightly to compensate for the improved treatment of those in the double-A category, and that the former “lose a little bit of their edge” over senior unsecured bonds, but that the aggregate effect after taking into account duration treatment is minimal.

However, the new rules have the biggest positive impact on AA rated covered bonds, he said, a crucial development given that the insurance sector is the only remaining investor group for which a downgrade of a covered bond to below triple-A has “significant economic meaning”.

A covered bond downgrade from triple-A to AA+ may no longer be a major concern, he suggested.

This is because the required spread difference for an insurance company that has an internal required rate of return on capital of 15% shrinks from 41bp in the 10 year segment to a “mere” 12bp, with the spread pick-up in the five year segment dropping from 23bp to only 9bp.

“We would expect the negative bias towards below AAA rated covered bonds, that we have from time to time witnessed in the insurance sector, to be much less of a factor now as long as we stay within the double A category,” said Eichert.