Fitch upgraded Bank of Cyprus covered bonds to B+ yesterday (Monday), following a downwards revision its refinancing stress assumptions for Cypriot residential mortgage loans financed through covered bonds.

Fitch yesterday reduced the B rating spread level (RSL) assumption from 1,500bp to 650bp, following a review that was triggered by an upgrade of Cyprus’s rating from B- to B+, which was also announced yesterday.

The rating agency said the lower RSL reflects a significant decrease in the observed yields of Cypriot government bonds since mid-2013, supported by the sovereign’s improving financial conditions and decreasing direct financial links to the Greek economy.

Fitch subsequently upgraded Bank of Cyprus’s Eu650m covered bonds by one notch, from B to B+, and removed them from Rating Watch Positive, placing them on stable outlook.

Fitch said the upgrade reflects the improved stressed valuation of the cover pool under the updated RSL assumptions of 659bp in a B+ scenario.

Assuming recourse would switch from the issuer to the cover pool, Fitch said this would provide recoveries given default in excess of 91% in a B+ stress scenario, commensurate with a three-notch uplift above the covered bonds’ rating floor represented by the bank’s IDR of CCC, plus one notch corresponding to the IDR uplift assigned to the programme.

The previous cover pool valuation supported recoveries given default commensurate with a two-notch uplift above the same floor, Fitch noted.

Fitch added that the rating of the covered bonds is constrained by the level of overcollateralisation (OC) that the issuer commits to, which stands at 47%. This level of protection does not support a timely payment on the covered bonds in rating scenarios above the rating floor, due to the high level of credit risk in the cover pool, it said. Fitch assumes a stressed credit loss of 37% in a B+ rating scenario and 61% in a BB- rating scenario.

Fitch said it recalculated the breakeven OC at the relevant rating scenarios with the revised RSLs. The B+ breakeven OC is 37%, which compares with the previous 31% B breakeven OC.

Fitch noted that Bank of Cyprus covered bonds have a conditional pass-through amortisation profile and, in its cashflow analysis, it does not factor RSL assumptions to test OC for timely payments because there is no forced sale of the assets. However, when measuring recovery given default prospect, Fitch incorporates half of the RSL in the stressed interest rate used to derive the net present value of the cover pool in a given stress scenario.