Fitch downgraded The Co-operative Bank two notches from BB- to B, and put it on Rating Watch Negative, yesterday (Thursday), with a covered bond cut now expected, although an analyst suggested this could be by only one notch.

The UK bank announced a new recapitalisation plan on 4 November and Fitch said that its downgrade reflects the impact the revised strategy is likely to have on The Co-op’s internal capital generation ability, as well as taking into account other new disclosures.

“Fitch considers that the new strategy, including the deleveraging of some non-core portfolios, while ultimately beneficial for senior debt-holders in the long term if successful, to pose significant challenges over the medium term and preclude the bank from being capital generative for some time,” it said. “In addition, Fitch believes that the reduction of the Co-operative Group’s stake to 30% as a result of the liability management exercise (LME) has the capacity to diminish Co-op Bank’s small but stable domestic franchise and loyal customer base.

“The ratings factor in some benefit from Co-op Bank’s acceptable liquidity and so far stable funding profile.”

It added that the Rating Watch Negative reflects “material risks” to the success of the LME.

An analyst at RBS said that according to Fitch’s criteria, the probability of default (PD) rating of The Co-op’s covered bonds should fall to BB+ (assuming an unchanged D-Factor of 4). As the maximum achievable recovery uplift above the PD rating will be three notches, because the PD rating is now sub-investment grade, rather than the previous two, the recovery uplift could be increased by one notch, according to the RBS analyst.

“Therefore we would assume the covered bonds to be downgraded by one notch to BBB+ as a base case, although there is a risk that they downgrade it by two notches in case stressed recoveries are lower than previously assumed (if Fitch came to the conclusion that the cover pool quality has deteriorated in the meantime for example),” he said.