Fitch yesterday (Monday) announced final amended covered bond rating criteria to reflect the asset class’s beneficial position under bank bail-in frameworks, changing one of the criteria it consulted on, with RBS analysts seeing cédulas and double-A rated Pfandbriefe as among the main beneficiaries.

Fitch, Canary Wharf

The criteria update comes after a consultation period that ended on 31 January, with the rating agency having announced its proposed new criteria on 16 December.

Yesterday’s announcement means that Fitch is the first rating agency to come out with final criteria in response to bank resolution frameworks, most notably the EU Bank Recovery & Resolution Directive (BRRD), which provides for the bail-in of senior unsecured debt but in general excludes covered bonds from such treatment.

“Fitch’s analysis of covered bonds now incorporates a further uplift above the bank’s Issuer Default Rating (IDR) if certain conditions are complied with (the IDR uplift),” said the rating agency yesterday. “No other criteria changes have been introduced.”

Nearly three-quarters of the covered bond programmes publicly rated by Fitch (92 of 129) are expected to be eligible for such a further uplift above a bank’s IDR, according to the rating agency, although the uplifts would not lead to many upgrades given that around 60% of outstanding covered bonds are rated at the highest level.

“The assigned IDR uplifts will have a limited positive impact on current ratings,” said Fitch.

Based on Fitch’s preliminary review, the IDR uplift could reach two notches for 42% and one notch for 30% of the affected programmes, and no programmes would be assigned a three notch uplift. The remainder of the programmes would not be assigned an extra IDR uplift, “as they are deemed eligible for an uplift due to their exemption from bail-in but currently do not meet the criteria for a higher uplift”.

For programmes of issuers with IDRs in the BB category and above and eligible for uplift, the IDR uplift could range from zero to two notches, according to Fitch, while for programmes of issuers with IDRs in the B category and below the uplift could range from zero to three notches.

RBS analysts today (Tuesday) noted that French, German, Spanish and certain Danish programmes will benefit from at least one notch of uplift, which will increase the cushion against IDR downgrades in case the covered bond rating is already at triple-A or is constrained by OC or sovereign risk.

“Cédulas seem to be among the main beneficiaries of this proposal as well as some Pfandbriefe rated in the AA range,” they said. “Those French programmes which are rated below AAA have been constrained either by their sovereign risk or by OC.

“Important will be the net effect including potential negative rating actions on bank IDRs due to lower systemic support.”

Although Fitch’s criteria revision was prompted by the view that covered bonds have a beneficial position under the BRRD, the rating agency noted that the final BRRD compromise text published by the European Council in December “implies that covered bonds issued by non-deposit taking specialised mortgage credit institutions could bear losses in the event of a resolution”

As a result, Fitch expects that covered bond programmes of Danish mortgage credit institutions will not be eligible for an uplift under its new criteria. These will be rolled out across EU covered bond programmes, although those of issuers based in Switzerland and New Zealand could, subject to further regulatory review, also be included.

Single deviation from exposure draft

On the back of feedback provided during the consultation, the rating agency’s final criteria incorporate one change from the proposed version. This is with respect to one of the three factors that determine whether a programme would be eligible for an IDR uplift, and concerns the amount of senior unsecured debt serving as a buffer to absorb losses.

Fitch had initially proposed as a threshold an amount equivalent to common equity plus junior debt and worth at least 10% of total adjusted assets. Instead, under its final criteria programmes can qualify for a potential IDR uplift if the outstanding level of senior unsecured debt represents at least 5% of total adjusted assets (adjusted for derivatives and insurance assets).

“Fitch believes that the 5% threshold provides a meaningful protection against financial shocks, serving as a significant buffer if equity and other junior instruments prove insufficient to restore viability to a failing bank,” it said. “It is also a reasonable proxy for minimum total capital/risk-weighted assets that a bank is likely to be required to maintain under Basel III in most jurisdictions.”

It added that the protection offered by capital and junior debt is already captured in the IDR and is therefore not relevant for uplift considerations for covered bonds.

“A high level of senior unsecured debt provides additional protection to covered bondholders beyond debt already captured in the IDR and therefore further lowers the probability of the cover pool becoming the source of principal and interest payments on covered bonds,” it said.

To qualify for an additional IDR uplift programmes must meet at least one of three factors, one of which is the aforementioned buffer provided by senior unsecured debt. If at least one factor is met a one notch IDR uplift could be granted, and at least two notches if two are met.

RBS analysts said that a three notch uplift can only be granted for issuers rated B or lower in exceptional circumstances when idiosyncratic factors result in the low issuer rating rather than systemic jurisdiction-specific factors.

The other two factors relate to, in Fitch’s words, “the relative ease and motivations for resolution methods other than liquidation” and the importance of covered bonds to the financial markets in a given jurisdiction.