Fitch is proposing to reflect covered bonds’ planned exemption from bail-in under the pending EU bank resolution regime by introducing an uplift above an issuer default rating to serve as a new starting point for covered bond ratings, depending on factors such as systemic importance.

Fitch, Canary Wharf

The rating agency announced the proposed criteria change yesterday (Monday) and is inviting feedback until 31 January 2014. It said that it expects a limited positive rating impact from the proposed amendment because of the limited number of jurisdictions that Fitch considers to be covered bond intensive and because around 60% of the programmes it rates are already rated AAA, especially outside peripheral euro-zone countries.

For issuers with issuer default ratings (IDRs) in the BB category or higher, Fitch is proposing to set the starting point for its covered bond rating analysis two notches above the IDR.

“The degree of notching will depend on Fitch’s opinion regarding the relative ease and motivations for resolution methods other than liquidation, the importance of covered bonds to the financial markets in a given jurisdiction and any buffer offered by senior unsecured debt,” said the rating agency.

A two notch uplift will be granted if at least two of the three factors are present, according to the rating agency, one notch if at least one of the three factors is present, and no uplift if none of the three factors is present.

For issuers with IDRs in the B category or below, the starting point could be up to three notches, i.e. one category, above the IDR depending on the same factors and bank-specific considerations, according to Fitch.

Jurisdictions that Fitch identified as “covered bond intensive” are: Germany, Denmark, France, Norway, Spain, and Sweden.

In these countries, Fitch said, “there will be even less political or regulatory will to risk contagion and test the effects of segregating a cover pool from the issuing institution”.

“Fitch expects banking authorities to aim to avoid exposing investors to a value-destroying sale of cover assets to make timely payment on covered bond obligations,” it added.

Bernd Volk, head of covered bond research at Deutsche Bank, highlighted that Italy was excluded from this list, a detail he said he doubts will “survive the consultation”.

“The argument seems to be based mainly on systemic importance,” he said. “In our view, with Eu50bn of publicly outstanding covered bonds and over Eu50bn retained issues, Italian covered bonds are systemically important.”

After the consultation phase and after it has finalised the criteria amendment, Fitch expects to take any covered bond rating changes at the same time as bank IDR changes where they relate to bank resolution developments or support.

“Fitch believes this is the most effective way of reflecting these issues in its covered bond ratings without multiple rating actions being taken which are driven by similar reasons,” it said. “Where outlook changes or rating actions are taken on support-driven banks’ IDRs prior to the completion of the covered bond criteria amendment, Fitch would refrain from taking outlook changes or rating actions on covered bonds until it has finalised its criteria changes.”

The rating agency estimates that around 9% of covered bond ratings – corresponding to 24% of non-AAA rated programmes – could be placed on positive outlook if the starting point for applying its covered bond rating criteria is changed as proposed.

“However, the proportion of positive outlooks would be lower if the weakening or removal of support for banks negatively affects the outlook on an issuer’s IDR,” it said.

The proposed criteria amendment is a response to the development of an EU bank resolution framework that defines resolution tools for banks including the bail-in of senior unsecured debt while covered bonds are set to be exempt from such writedowns.

“In a resolution scenario, a bank’s non-performance on its senior unsecured debt will not automatically lead to a switch of the source of payment from the issuer to cover pool to repay covered bonds and a bank may be restored to a going concern,” said Fitch.

A tripartite EU agreement on key elements of the Bank Recovery & Resolution Directive was reached last week, but although the main features of the draft directive are in line with earlier versions a revised text is not available. Fitch is basing its proposed criteria change on provisions of a June 2013 draft Bank Recovery & Resolution Directive published by the European Council.

It said that it initially intends to apply the amendment to EU covered bonds, as well as those from Switzerland and New Zealand because resolution measures are also advanced there and include similar exemption provisions for covered bonds.

Fitch noted that despite a potential uplift, covered bond ratings will remain dependent on the level of overcollateralisation (OC) relied upon to sustain relevant stresses.