Covered bond ratings are characterised by a high degree of stability but nearly one-third face an automatic downgrade if Standard & Poor’s cuts the issuer, the rating agency said yesterday (Monday), noting that European banks face difficult credit conditions.

In the rating agency’s latest quarterly report on covered bond ratings and characteristics S&P said the number of covered bond rating changes over the preceding quarter was at its lowest since it started publishing metrics in 2010.

“Indeed, most of our covered bond ratings have shown a high degree of stability, and two-thirds are still at AAA,” it said. “That’s because issuers have managed overcollateralisation levels or amended the terms of their programmes, such as regarding swap counterparties considerations.”

Most of the downgrades of covered bond ratings in 2012 reflected a change in S&P’s view on country risk in Europe, according to the rating agency.

However, it said that covered bond ratings are in a “fragile equilibrium” because many financial institutions face several challenges in transitioning to more sustainable balance sheets, and that the stability of its ratings on European banks and therefore their covered bonds remains delicate.

“Following consecutive rating actions on various European sovereigns throughout 2012, and the impact on our bank ratings, the share of covered bonds without unused notches of uplift has increased,” said S&P. “A downgrade of an issuing or sponsoring bank would therefore directly result in a downgrade of the covered bond.”

The average issuer credit rating on covered bond issuers is still high, at A-, according to S&P, so only 29% of its covered bond ratings carry negative outlooks or are on CreditWatch with negative implications, signalling that a downgrade of the issuer would automatically lead to a cut of the covered bond programme.

S&P pointed to credit risk information available in its Global Covered Bond Characteristics report, noting that it is important for investors to be able to gauge the level of this risk and that it varies widely across Europe.

It noted that its figures show Spain and Ireland as the countries where credit risks to asset pools for rated mortgage covered bonds are the highest, and suggested that in the financial markets Italy and Portugal were often incorrectly associated with this group.

“Our credit risk estimate for mortgage covered bonds in Italy is relatively low, as it is in Portugal,” it said. “Notably, both figures are lower than the median for all covered bond programmes, as well as those for Germany, Denmark, and the UK.”

Maureen Schuller, head of covered bond strategy at ING, said that the relatively stronger characteristics of the cover pool assets of Italian covered bonds versus Spanish covered bonds, as measured by the lower credit risk, continues to explain the wider Italian senior unsecured over covered bond spreads, compared with Spanish senior unsecured versus covered bond debt.

Asset-liability mismatch (ALMM) risk is a key component in S&P’s rating approach, and S&P noted that for the mortgage covered bonds it rates the median target credit enhancement to offset credit risk was 4.62%, but five times higher, at 24.62%, including ALMM risk.

“Depending on where a programme was issued, however, absolute amounts of credit enhancement to support a covered bond rating can also differ: from 6.8% for the two Canadian programmes we rate, to about 78.4% (more than three times the median) for rated Spanish programmes,” said S&P. “At the same time, the lowest target credit enhancement for a Spanish programme was 47.6% and the highest 88.2%, which also demonstrates the effect of variances among covered bond risk characteristics within a country.”