Increased transparency in the covered bond market will be crucial in 2015 as compressed spreads partially mask differentials in risk levels, Scope Ratings said today (Thursday), while forecasting that the asset class will maintain momentum next year.

In research offering its outlook for covered bonds and securitisation, the rating agency said that supportive regulatory developments, stable and positive bank ratings, and other favourable conditions will keep demand for covered bonds high in 2015.

However, citing a scarcity of new mortgage collateral and the availability of other funding – such as that raised when financial institution are issuing Additional Tier 1 and other capital instruments – Scope said net supply is likely to remain negative in 2015, with redemption volumes outstripping new issuance in Europe, which it expects to be comparable to 2014. Meanwhile, the European Central Bank’s third covered bond purchase programme is contributing to spread compression, it added.

The rating agency said it is this imbalance between supply and demand that has caused spreads to tighten to pre-crisis levels, rather than a decreasing level of credit risk. Scope said that credit risks for covered bonds, including refinancing risks and risks on cover pool assets, differ widely between European countries and have not fallen as significantly as spread compression might suggest, warning that investors should remain wary.

“In our view this reduces the willingness of investors to contrast and compare the risks they are exposed to,” Scope said, noting that when spreads are tighter investors tend towards covered bonds trading at the highest spreads, which are the most risky.

“As covered bonds are increasingly viewed as a ‘rate’ product again, credit considerations receive lower attention than before,” it said. “We believe that from a rating perspective, investors should remain selective in their investments because underlying credit risk and risk tiering will be hidden by a technical supply/demand imbalance.”

Noting a trend towards longer maturities in recent issues, Scope said investors should make efforts to assess cover pool risks, in case recourse is needed at time when liquidity may be more constrained than currently.

“Banks are operating in a more challenging environment and the anchor point for the covered bond rating, the ratings of the issuers, are now lower than before,” said the rating agency. “While some covered bonds have also experienced negative rating migration, the average covered bond rating remained on average almost at the previous level.

“Averages can obfuscate, however. Covered bond ratings today span a much wider range … with B+ today the lowest covered bond rating outstanding, well below investment grade, indicating that higher scrutiny and differentiation is warranted.”

To enable a more holistic and balanced analysis of these risks, Scope said investors should continue to call for more forward-looking statements from issuers, predicting that transparency will be a key theme for the covered bond market in 2015. It noted that efforts such as the European Covered Bond Council’s Label initiative have already encouraged issuers to disclose more information, but said more needs to be done.

“This is also important for covered bond ratings as the potential volatility of the collateral composition and mitigants form an important part of the covered bond credit risk evaluation process,” Scope added.