Pressure on European mortgage borrowers has recently increased credit risk in some covered bond programmes, said S&P in a 2013 outlook yesterday (Thursday), which also discussed niche products, the potential for supply in the US and elsewhere, and the Covered Bond Label.

The rating agency said that by January this year it had lowered ratings on more than 25% of covered bond programmes outstanding a year earlier, and that one in three programmes are on negative outlook, in many cases because of similar outlooks on the sponsor bank or sovereign rating (see chart). This suggests that some programme ratings may come under pressure this year as well, said Standard & Poor’s – Covered bonds face another tough year is the title of the rating agency’s outlook.

In the third quarter of 2012 asset default risks in mortgage covered bond programmes rated by S&P required overcollateralisation of about 15%, it said, up from about 10% in the second quarter of 2011, in part due to increases in Spain.

“Nevertheless, for the most part, banks continue to maintain OC levels that are sufficient to maintain achievable ratings,” it said, adding that the average actual credit enhancement level has remained fairly steady over the past several years at more than 50%, while target credit enhancement necessary to maintain ratings has remained close to 30%, although these figures vary considerably by country.

“We have also witnessed banks raising levels when necessary to support ratings.”

However, not all issuers have maintained target credit enhancement levels, added S&P, such as some issuers that have come under stress and have had to be bailed out or restructured.

“For banks that see their programmes as an important part of their continuing activities post-restructuring, we have seen OC levels maintained or even increased to shore up market support,” said the rating agency, “and we believe this will continue.”

The record is more mixed for banks that have chosen to wind down covered bond programmes, according to S&P.

“Some have maintained but not increased levels, while others have purposefully withdrawn OC, which has resulted in lower ratings,” it said.

High redemptions and tighter spreads could keep issuance volumes broadly in line with those of 2012 despite reduced funding needs, according to the rating agency. It said that it expects significant volumes from relatively new jurisdictions such as Australia and Belgium, and noted that in the UK, for example, covered bond spreads have tightened more than those for senior residential mortgage-backed securities (RMBS).

“We expect that attractive pricing will prompt opportunistic placements this year, despite lower funding needs,” it said.

A perennial reference to possible Latin American issuance is also made, with the rating agency noting that “Mexico and Chile might see some issuance in 2013”. Panama’s Global Bank last year sold the first ever internationally targeted Latin American covered bond.

Looking to the US, S&P said that it “remains a question mark”. Positives cited include strong interest in covered bonds from US investors and the first ever fully SEC registered issue. It said that the recent end of the presidential election cycle could provide an opportunity for legislators to refocus on passage of covered bond legislation.

However, even with legislation in place covered bond placements might still not make economic sense for many potential issuers in the short term because of the outsized role of government sponsored enterprises (GSEs) in providing mortgage finance.

A wish to fund “esoteric” assets led to some non-traditional covered bond issuance in 2012, said S&P, pointing out that NordLB sold the first ever aircraft Pfandbrief, that the Spanish government passed a law creating a new type of covered bonds backed by export credits (see here for previous coverage), and that Commerzbank has set up a structured programme backed by SME loans.

“We expect aircraft Pfandbrief to remain a niche product, but SME-backed issuance may have more potential, in our view, given the importance of small business lending to European economies,” said S&P.

However, factors such as the non-standard nature of many SME loans and the lack of industry-wide collateral quality criteria could complicate SME covered bond analysis for investors.

“For the time being, SME covered bonds also remain ineligible for favourable regulatory treatment (for example, in bank capital rules), which may limit take-up,” it added.

The European Covered Bond Council’s Covered Bond Label was also noted by S&P, which said that it views the initiative as a “medium term positive” for issuance from certain countries.

“As covered bonds continue to expand into more jurisdictions, we believe that investors could value the additional transparency associated with labelled issues,” it said.

Covered Bond Programmes Outstanding in January 2012 with a Lower Rating in January 2013 by reason for downward rating transition

Note: Downward rating transitions over the period include programmes that were downgraded before S&P withdrew the rating.

Source: S&P