Changes proposed by Moody’s in response to the introduction of a bail-in regime could result in upgrades of one or two notches for the majority of European covered bonds not rated Aaa or at their country ceiling, it said in a request for comment yesterday (Thursday).

Market participants have been calling for rating agencies to relax the link between covered bonds and senior unsecured ratings in light of the forthcoming EU bail-in framework. They have argued that while bail-in will make senior unsecured debt riskier it will benefit covered bonds, but that without changes to methodologies cuts to senior debt could drag covered bond ratings lower. However, the rating agencies have hitherto said that too many questions remain about how the new regime will be implemented.

In its request for comment (RFC) yesterday, Moody’s cited an agreement reached by the EU Council and ECOFIN on 27 June on a draft of the proposed EU directive on bank resolution.

“The Directive calls for the resolution of bank failures through the bail-in of unsecured bank debt and certain deposits, while explicitly exempting covered bonds from the bail-in process,” said the rating agency.

Volker Gulde, vice president and senior credit officer at Moody’s, told The Covered Bond Report that, coming after earlier moves towards a new regime, the directive was a “tipping point” in the rating agency’s thinking.

“It’s pretty clear now where the journey is going,” he said.

As a result, Moody’s is proposing changing the issuer anchor point for covered bonds, which is the reference point for covered bonds before collateral benefits are considered, with the potential credit benefits deriving from the bail-in directive’s implementation depending upon the amount of bail-in-able debt.

The anchor point will change from being the senior unsecured rating (SUR) to the higher of: the adjusted Baseline Credit Assessment (BCA) plus up to two notches; or the SUR plus up to one notch.

“The addition of the adjusted BCA as an anchor point for our covered bond analysis represents a significant evolution in our thinking because, thus far, we have in almost all cases used the SUR,” said the rating agency. “We propose adding the adjusted BCA as an anchor point as it allows us to determine the benefit to covered bondholders provided by the ‘internal support’ of the bail-in aspect of the Directive.

“However we still maintain the SUR as an anchor point to capture situations in which ‘external support’ may be greater than that implied by bail-in loss absorbing capacity.”

Where driven by adjusted BCA, Moody’s expects the issuer anchor to be two notches above the adjusted BCA where an issuer has an unsecured senior and subordinated debt/total liability ratio of 10% or higher, one notch higher when this is 5%-10%, and no uplift when lower than 5%.

The rating agency said a greater uplift could be considered when there are substantial additional levels of bail-in-able debt.

Moody’s described the planned changes as an “initial step”, with further changes possible as it emerges how the directive will be implemented and applied. This could result in not only changes to the issuer anchor point, but also other elements of Moody’s methodology, such as its Timely Payment Indicator (TPI) measure.

The proposed changes would apply to the EU and also Norway, where the rating agency expects a similar regime to be implemented.

Moody’s said of covered bonds that are neither rated Aaa nor at their country ceiling, a majority could be upgraded by one to two notches, in some cases depending on whether issuers choose to add further overcollateralisation.

“On average, the covered bond issuers affected by this methodology change currently show a robust bail-in absorption capacity, as evidenced by an average unsecured senior and subordinated debt/liability ratio of around 16%,” it said. “Thus, we expect that the majority of covered bonds affected will have uplift over adjusted BCA of +2, with smaller numbers at +1 or 0.”

Moody’s has requested comments within one month, and asked for feedback specifically on three issues, in its words:

• Are the proposed levels of bail-in-able debt appropriate to achieve 1-2 notches of uplift?

• Should we consider uplift beyond +2 notches above the adjusted BCA and/or +1 notches above the SUR?

• Should the number of notches for external support and loss absorbing capacity due to bail-in be strictly additive, or should we assume some trade-off between the two: for example, limiting credit for bail-in-able debt when we have assumed a high degree of support in the SUR?

Bernd Volk, head of covered bond research at Deutsche Bank, said that while it remains to be seen how Moody’s proposals will play out and how investors and risk managers will react, they are clearly positive for EU and Norwegian covered bonds, particularly in the case of lower rated banks.

“Needless to say, most of the comments that Moody’s receives will support the changes,” he added.

Luca Bertalot, head of the European Covered Bond Council, said that Moody’s proposals are a “welcome step forward” and that the industry body will be meeting with the rating agency ahead of delivering an official response to the RFC.