The establishment of the first covered bond programme under South Korean legislation by Kookmin Bank (KB) highlights the availability of a new funding option for Korean banks and improves protection for investors, Moody’s said today (Monday), as the rating agency assigned a provisional rating of Aa1 to Kookmin’s planned debut and Fitch an expected AA+ rating.

Previous Korean issuance has either been on a contractual basis or, from Korea Housing Finance Corporation (KHFC), under legislation specific to the institution. A mandate for an inaugural issue by Kookmin under legislation that came into effect in April 2014 and off an $8bn (Eu7.10bn, Won8.93tr) programme was announced on Thursday.

“Unlike previous Korean covered bonds, Kookmin’s transaction is a multi-series programme that allows for more timely issuance,” said Joe Wong, a Moody’s analyst. “As observed in other countries, covered bond markets have stayed open and provided banks with more readily available funding even during financial crises.”

Moody’s said in a report that covered bond programmes in Korea also help mitigate a rising level of interest rate risk at banks because of an increasing proportion of fixed rate mortgages, which are in turn driven by regulatory requirements. Covered bonds will provide an alternative for banks to manage their long term assets and liabilities, in addition to selling conforming mortgage loans to KHFC, according to the rating agency.

This alternative source of funding will particularly benefit commercial banks with sizable mortgage loan books, it said. As of December 2014, Kookmin had the biggest mortgage loan book, according to Moody’s, followed by Woori Bank and Shinhan Bank.

“Kookmin’s new covered bond programme features a pre-maturity test and maturity extension, which were not present in previous Korean covered bond transactions,” said Moody’s. “These features reduce the need to sell the mortgage loans in a short time, which could attract large market value loss given the illiquid nature of Korea’s secondary mortgage market.

“The new programme can be a precedent for future programmes to adopt similar features to mitigate such risk.”

Structural elements such as a 12 month pre-maturity test and a liquidity reserve to be funded by the issuer upon breaching a rating trigger were cited by Moody’s when it assigned its provisional Aa1 rating. It also cited a covered bond anchor of Kookmin’s Counterparty Risk assessment (Aa3) plus zero notches, a collateral score of 9%, and a Timely Payment Indicator of “improbable”.

“Committed” overcollateralisation (OC) is 17%, while expected cover pool losses are 28.6%, split between 22.6% market risk and 6.0% collateral risk. Moody’s said that the minimum OC level consistent with the Aa1 rating target is 5%.

“Subject to certain requirements, the issuer can change this OC commitment so long as the revised OC commitment is consistent with the current Moody’s rating of the covered bonds,” it added. “Such flexibility will be reduced once the covered bonds have been downgraded.”

The rating agency highlighted as positive aspects of Korean legislation: the ring-fencing of cover pool assets from an issuer’s bankruptcy estate; issuer insolvency not triggering acceleration of the covered bonds; the segregation of transaction accounts from an issuer’s bankruptcy estate; and having an asset monitor responsible for monitoring the cover pool on an ongoing basis, as well as managing or disposing of the cover pool.

“Based on both the strength of the Covered Bond Act and the structural mechanisms implemented, we believe that refinancing and operational risks are to some extent mitigated,” said Moody’s. “Nevertheless, the refinancing risk of the programme is still higher than that in other developed covered bond markets given the lack of a liquid secondary mortgage loan market in Korea.

“Thus, it is less likely that timely payments to covered bondholders would continue following a covered bond anchor event.

Fitch cited as key rating drivers Kookmin’s A rating, a Discontinuity Cap (D-Cap) of 4, and an asset percentage (AP) expected to be lower than or equal to a AA+ breakeven AP of 85.5%. The rating agency said that the D-Cap of 4 reflects a discontinuity risk assessment of “moderate” related to the liquidity gap and systemic risk and cover pool-specific alternative management components of Fitch’s analysis. The rating has a stable outlook, reflecting that on Kookmin’s rating, it added.

The cover pool comprised 16,311 loans secured by first ranking mortgages of Korean residential properties with a total outstanding balance of Won2.34tr as at the end of April, according to Fitch, with a weighted-average current loan-to-value ratio of 43.4% and is 18 months seasoned. By current balance, 50.1% of the pool comprises loans with an interest-only period that covert to full amortisation, 86% of the loans are hybrid loans of floating and fixed rate, and 98.4% of the loans are secured by apartments, it added.

Fitch said that the cover pool is geographically diversified across Korea, with the largest exposures in Kyounggi (42.5%) and Seoul (29.8%).