A Swiss National Bank decision to abandon last Thursday a cap on the value of the Swiss franc will be credit negative for the covered bonds of Swiss and Austrian banks, Moody’s said today (Monday), warning that the Austrian market is particularly exposed.

The announcement by the Swiss National Bank (SNB) that it would dispense with the Sfr1.20/Eu exchange rate cap and return to a free-floating currency caused a sharp appreciation in the Swiss franc.

Noting that while the move is credit positive for the Swiss sovereign, Moody’s said today that the removal of the peg is credit negative for Austrian, Polish and Swiss banks, and to covered bonds exposed to euro/Swiss franc exchange rate risk.

Moody’s noted that the cover pools of some euro-denominated covered bonds are backed by Swiss franc-denominated loans to borrowers or entities that receive income in euros, while Swiss franc-denominated covered bonds are also exposed when backed by euro-denominated collateral. It said that the Swiss franc loans do not typically contain a mechanism to control Swiss franc appreciation, meaning that borrowers will find it harder to make increase repayments, and in turn that higher rates of default are likely should the cover pool assets be required.

The rating agency noted that Swiss franc appreciation increases the nominal value of the claim covered bondholders have against Swiss franc borrowers, but said that overall this positive effect is outweighed by the negatives.

While investors are protected from shortfalls caused by a mismatch between assets and liability as long as the issuer continues to operate, should the bank fail, covered bondholders must rely on any mitigating features that may exist in the cover pool or the programme, the rating agency said.

“Typically, nominal value tests ensure that up to the point of issuer failure, any shortfalls are covered,” said analysts at Moody’s. “Alternatively, hedging with cross-currency derivatives can also reduce or remove currency exposures, as long as the swap survives issuer default.

“Neither of these mitigants are foolproof and the higher the currency stress, the greater the risk that protections in place may not be sufficient. In an extreme case, cover pool collateral may suffer no credit losses, but currency movements may mean asset cashflows are insufficient to repay covered bonds.”

Governments may also act to ease the pressure on borrowers, said Moody’s, citing a prior move by the Hungarian parliament to force banks to accept an off-market exchange rate from borrowers, which led to a write-down of the value of loans and therefore a reduction in the value of cover pool collateral unless substitutions are made.

Most affected are Austrian covered bonds, where on average 17% of mortgage covered bonds’ assets are denominated in Swiss francs, according to Moody’s, which noted that Austrian households face Swiss franc exposure of Eu25bn, according to the Austrian Financial Market Authority.

Exposure to Swiss franc-denominated cover assets varies significantly between programmes, added Moody’s, with Vorarlberger Landes- und Hypothekenbank (Hypo Vorarlberg), UniCredit Bank Austria and Erste Group Bank most affected, with 28%, 22% and 16% exposure, respectively.

Meanwhile, the public sector covered bonds with the highest levels of covered bond exposures to the Swiss franc are those of Hypo Alpe-Adria-Bank wind-down entity Heta Asset Resolution (21%), Kommunalkredit Austria (13%) and Hypo Vorarlberg (11%), Moody’s said.