Covered bond issuance and other secured funding by certain banks is reducing the probability of them failing, according to Fitch, and there is a trade-off between structural subordination and a low default rate, the rating agency noted in a report today (Thursday) exploring issuance and encumbrance issues.

A report published by the rating agency said that European covered bond issuance in the first quarter of the year was broadly unchanged compared with last year, and that total outstanding covered bond volumes relative to the aggregated balance sheets of European banks rated by Fitch is at the same level in 2011 as in 2010, at roughly 6%.

Covered bond issuance represented 43% of European bank debt issuance overall in the first quarter of this year, a proportion generally in line with the three previous years, according to Fitch. It was slightly lower than in the first quarter of last year, reflecting lower bank debt issuance overall.

The rating agency highlighted that there were data limitations in its analysis, saying that data are based on a crude ratio of outstanding covered bonds on total balance sheet, partly because of the lack of disclosure on pledged assets (mainly loans and, to a lesser extent, securities) and on overcollateralisation. It said that it has not adjusted the balance sheet total for intangibles or for unfunded items such as derivatives or insurance liabilities.

Fitch also noted that trends vary across different jurisdictions.

While outstanding covered bonds increased by only 2% in 2011, annual growth was “a substantial 21%” if programmes in the established covered bond markets of Germany and Spain are excluded, it said.

“Some eurozone issuers showed notable growth in covered bonds outstanding despite stable or slightly shrinking balance sheets, in many cases due to retained issuance for central bank repo operations,” said Fitch. “Countries with relatively new covered bond markets, including Australia and New Zealand, showed high growth but from a very low base.”

The rating agency attributed a continued high share of covered bonds to: difficult access to unsecured markets for vulnerable banks; the possibility of senior unsecured bonds being bailed-in; heightened cost of unsecured funding; and favourable regulatory treatment as liquid assets.

It said that it expects covered bond issuance to remain a preferred funding source for banks, and that although it is rising in some banks it does not view increasing dependence on covered bonds as a risk for any of the banks it rates.

“For non-specialist issuers, the importance of covered bonds to a bank’s overall funding structure depends on the extent to which the bank is able to fund loans with deposits, and deposit funding is increasing in many banks,” it said.

The majority of the banks in Fitch’s sample fall into a 0%-10% bucket with regard to the share of covered bonds of an institution’s total balance sheet, according to Fitch, reflecting the importance of customer deposits in the funding structure of many universal banks as well as relatively new covered bond legislation in some countries.

“At the other end of the scale, the small number of banks that appear in the 50%-70% bucket are all specialised mortgage institutions, generally in markets with deep and mature covered bonds (or historically mortgage bonds), including Germany, France and Sweden,” said Fitch. “Their business models have been developed and driven by using covered bonds as their main funding instrument from inception.”

Asset encumbrance has increased during the past two to three years, said Fitch, particularly for southern European banks, due to increased secured funding and requirements for additional collateral. Various types of secured funding have replaced senior unsecured issuance for southern European banks since May 2011, said Fitch.

“Covered bond issuance is only a small part of the story, and a significant, but not easily quantifiable from public disclosure, part of these banks’ assets is pledged for central bank facilities and other collateralised funding transactions,” said Fitch. “The relatively modest increase in covered bond issuance overall in 2011 needs to be placed into this new context.” It said it is also important to note that very little of the covered bond issuance by southern European banks in 2011 and 2012 has been placed in the market; most has been retained by the banks, with the bonds used as collateral, primarily for liquidity and funding facilities from the ECB.

However, Fitch said that covered bond and other secured issuance have reduced funding pressure on those banks unable to fund on an unsecured basis, consequently reducing the probability of these banks failing. But by posting collateral fewer assets would remain for senior unsecured creditors in case of default, increasing potential loss rates, it added, with investor sentiment therefore “lying in the trade-off between structural subordination and low default rate for banks”.

A covered bond analyst said that it is important to analyse asset encumbrance on a bank-by-bank basis.

Fitch noted that overcollateralisation has increased but varies hugely, and is a function of asset and liability mismatches, refinancing costs, cover pool credit quality and local regulatory requirements.

“For example, in Spain, the mandatory minimum overcollateralisation for cédulas hipotecarias is 25% based on the eligible part of the mortgage book (irrespective of the fact that the entire mortgage book is available for the prior redemption of cédulas hipotecarias in the event of issuer insolvency),” it said. “Also, issuers may be registering assets in the cover pool ahead of future covered bonds issuance, which contributes to inflated overcollateralisation.”