Fitch is changing the way it evaluates recovery prospects in defaulted covered bonds where there is time subordination, it said today (Tuesday), which is expected to lead to lower breakeven OC for affected programmes, such as Portuguese and French legislative issuance.

The rating agency said that it will “more accurately” model stressed recoveries given default in covered bond programmes where there is time subordination.

Time subordination arises when proceeds from the cover pool in the event of it being overindebted are not allocated pro-rata across outstanding bonds but allocated sequentially in order of maturities, meaning that later maturing covered bonds are at risk of suffering a loss while an earlier series could be repaid in full.

In such cases Fitch’s prevailing approach is to only recognise recovery benefit when stressed recoveries reach 100% of covered bonds deemed to be in default, including the last maturing bond.

Hélène Heberlein, managing director of Fitch’s covered bonds team, told The CBR that this meant that the recoveries on the last maturing bond were the driver of any uplift for all the other, earlier bonds, given that the rating agency thinks it makes sense to rate all covered bonds backed by a cover pool the same.

“Given this constraint we felt a need to calculate recoveries slightly differently whenever recoveries would be allocated in sequential order of original maturities,” she said, “and the new model is more precise because we no longer assume that a fire sale is necessary, which means that you do not have to apply harsh refinancing cost assumptions as you would if there was a liquidation.

“Our overall framework for recovery uplift is not changing,” she added. “In particular, nothing changes for programmes where recoveries would be shared pro-rata between all bonds. However, the new modelling is less conservative than before for programmes subject to the risk of time subordination of recoveries.”

The rating agency will henceforth assume ongoing allocation of funds from the cover pool to make the payments that become due under the covered bonds, until the maturity date of the last maturing covered bonds, when the stressed value of the remaining assets will be assessed.

This is expected to lead to lower breakeven overcollateralisation in line with a given rating scenario for the concerned programmes, such as Portuguese and French legislative covered bonds, according to Fitch, although the OC level will still be higher than that for a programme where there is no time subordination.

Fitch said that it will apply its new approach over the next six months to cases where its analysis rests on the time subordination of later maturing covered bonds, which is analysed on a jurisdiction by jurisdiction basis.

Another aspect of Fitch’s revised approach is to aggregate the size of the last maturing bonds up to a certain threshold where these are not large enough to represent a significant share of the total covered bonds outstanding.

“Sometimes the last bond can be very small,” said Heberlein, “and you would not want recovery prospects linked to that to be the driver of the potential recovery uplift for all bonds linked to that cover pool, so this is another change.”