Moody’s may revise its reference point for an “issuer default” for the purpose of covered bond ratings in reaction to the European bail-in framework, the rating agency said in an outlook publication today (Thursday) that forecast fewer downgrades in 2013 than this year.

The rating agency flagged the possibility of it repositioning its reference point for issuer default in reaction to the European resolution and recovery directive. This is likely to be finalised in 2013, and provides for a bail-in tool, which Moody’s said could lead to issuer ratings being downgraded.

However, this threat is mitigated by a greater likelihood of support for covered bonds following bail-in, according to the rating agency.

“In core jurisdictions, bail-in risk may not negatively affect covered bonds if, despite negatively affecting issuer senior debt ratings, bail-in does not translate to an increased risk of ‘issuer default’ in relation to the covered bonds,” said Moody’s.

This is because the effect of a bail-in can be to strengthen the failing institution’s financial position or because covered bonds may be transferred to a separate going concern entity.

“In both these cases, the covered bond programme would be (re-)housed within a functioning and solvent entity,” said Moody’s. “In core jurisdictions, where we would expect regulators to use resolution powers to benefit covered bonds, the likelihood that covered bonds will continue to be part of a ‘going concern issuer’ following the use of resolution powers means the issuer’s senior debt rating may no longer be the most appropriate reference point for ‘issuer default’.”

In non-core jurisdictions, however, issuers’ senior debt ratings are more likely to continue to be the correct reference point for issuer default, it said.

Moody’s outlook also addressed regulatory moves, especially in new jurisdictions, to limit covered bond issuance due to asset encumbrance concerns. It said that these could be beneficial if such restrictions improve issuer credit quality, but may also be credit negative if they downplay the importance of covered bonds as a funding source – compared with deposits, for example – and thereby make it more difficult for covered bonds to be refinanced following an issuer’s default.

Greater alignment of covered with issuer actions

The rating agency said that there will probably be fewer European covered bond downgrades in 2013 than in 2012, but that issuer and covered bond credit quality will remain under threat next year due to the prospect of further deterioration of European banks and sovereigns in particular.

“The high number of negative sovereign outlooks implies that sovereign risk will continue to exert negative pressure on issuers and Timely Payment Indicators (TPIs), in particular,” it said.

The ratings of Spain and Italy carry negative outlooks, and if the credit quality of these sovereigns declines Moody’s could lower TPIs to “very improbable”, which would negatively affect covered bonds. Six sovereigns rated between Aaa and Aa3 are on negative outlook (Austria, Belgium, France, Germany, the Netherlands, and the UK) although Moody’s said that it would typically review TPIs when sovereigns are cut to the single-A range.

And although negative outlooks on issuers persist across a broad range of jurisdictions, there are fewer issuers on review for downgrade or with negative outlooks than a year ago, it said.

Ratings dynamics will in 2013 will resemble those this year in that covered bond downgrades will continue to be less frequent than issuer downgrades, and, in stronger countries, the magnitude of covered bond downgrades will be lower than for issuers, according to Moody’s.

Dynamics will differ however, in that there will probably be greater alignment between the frequency of covered bond cuts and issuer cuts as TPI leeway continues to contract and as the level of issuers’ discretionary support to programmes falls, said Moody’s.

Compared with 10-11 months earlier, at the end of October fewer covered bond programmes had a TPI leeway in the 2-5 notch range, said the rating agency, with many of these featuring a leeway of one notch. In addition, the number of programmes assigned to a “not disclosed” category, typically associated with low or zero TPI leeway, has materially increased, with programmes moving mainly from the “0 notch” category, said Moody’s. (See chart below.)

The rating agency said that recently issuers have increasingly found it more difficult to provide, or in some cases elected not to provide or even removed, discretionary support for their covered bond programmes.

“One example is where issuers allow voluntary overcollateralisation levels to decline, thus reducing both the amount of collateral available to absorb existing cover pool risk and any surplus overcollateralisation available as a buffer against future increases in cover pool or issuer risk,” said Moody’s. “In Spain, for example, the weighted-average eligible overcollateralisation had reduced to 46% in Q1 2012 from around 81% in Q3 2008.”

Source: Moody’s