Fitch has proposed changes to its covered bond rating methodology – including redefining how it determines IDR uplift for covered bond programmes, with a new emphasis on undercollateralisation risk, and a replacement of D-Caps – which it said could lead to 23 upgrades and 10 downgrades.

In an exposure draft published yesterday (Wednesday), Fitch proposed what a covered bond analyst described as “far-reaching” changes to its covered bond rating methodology that would modify the different uplift factors above Issuer Default Ratings (IDRs) that lead to the potential maximum covered bond rating.

These proposals include changes to the calculation of IDR uplift, the introduction of a new payment continuity uplift (PCU) focussing on liquidity protection, and a move towards a loss-driven assessment of recoveries given default.

The rating agency said the proposals are being made with the aim of “making some rating steps more focused on the most relevant credit aspects”.

Under the proposed changes, Fitch said it would assign an IDR uplift of up to two notches to programmes in jurisdictions with advanced resolution frameworks where fully collateralised covered bonds and secured debt are exempt from bail-in, and where Fitch believes payments will continue to be made without recourse to the cover pool even if the issuer has defaulted on its senior debt.

The pre-condition, Fitch said, is that the risk of undercollateralisation is sufficiently low at the point of resolution.

“This is because covered bonds could still be subject to bail-in for the liability value that exceeds the value of the cover assets against which they are secured,” the rating agency said. “Based on its review of legal frameworks and contractual documentation, the agency believes minimum OC requirements, dedicated supervision, eligibility criteria for cover assets, periodic mortgage assets valuation and the existence of an asset monitor are effective safeguards against such a risk in many countries where it rates covered bonds.”

Fitch said that most programmes it rates in jurisdictions eligible for an IDR uplift will therefore be assigned a two-notch uplift when the IDRs or reference IDRs are driven by the intrinsic strength of the bank as expressed by its Viability Rating (VR), whereas those with a support-driven reference IDR would be eligible only for a one notch uplift.

“There are, however, some notable exceptions,” added Fitch.

The rating agency said that in Austria, mortgage fundierte Bankschuldverschreibungen (FBS) are less well protected against undercollateralisation risk compared with European peers, because a legislative maximum loan-to-value for the financed mortgage loans are lacking. However, it noted that some issuers commit to coverage eligibility criteria, and said it may consider the risk of undercollateralisation for mortgage FBS as being sufficiently mitigated, making them eligible for an IDR uplift. Meanwhile, some public sector Austrian covered bonds may not be assigned IDR uplift, given unhedged FX risk.

In addition, Fitch said Polish listy zastawne may no longer be eligible for an IDR uplift if regulatory authorities exempt their issuers from compliance with the minimum requirement for own funds and eligible liabilities (MREL).

The new approach to IDR uplift will also consider the degree of integration of an issuing subsidiary into its banking group, Fitch said, with a two-notch uplift assigned to programmes of issuing entities with a support-driven IDR that are highly integrated into a parent whose IDR is VR-driven and which are likely to be resolved together in case of need. Programmes of entities with a support-driven IDR that may be resolved separately from their parent or group and programmes issued by subsidiaries of a parent whose IDR is support-driven will be assigned a one-notch uplift.

Fitch said that this new IDR uplift approach would substitute the three conditions it currently considers: the relative ease and motivation for resolution methods other than liquidation; the importance of covered bonds to a jurisdiction’s financial markets; and the buffer provided by senior unsecured debt.

Fitch is also proposing to replace its Discontinuity Cap (D-Cap) assessment with the new PCUs – which are expressed in notches above the IDR adjusted by the IDR uplift, ranging from zero to eight.

It said the PCUs will assess whether, once recourse against the cover pool is enforced, liquidity mechanisms are sufficient to protect against payment interruption risk deriving from maturity mismatches between the cover assets and the covered bonds. Other components of the outgoing D-Cap assessment could nevertheless still constrain the PCU.

“As a benchmark, programmes with strong liquidity provisions, such as a 12 month maturity extension, will be eligible for a six-notch uplift in developed markets,” Fitch said. “Programmes with a conditional pass-through amortisation will have a potential uplift of eight notches.”

Fitch said it is also proposing to move towards a loss-driven assessment of recoveries given default.

“This is a change from the current approach,” the rating agency said, “where calculations may suggest a higher precision than that implied by the recovery ranges used by Fitch – good (51%-70%), superior (71%-90%) and outstanding (91%-100%) – and in line with an uplift of one to three notches.”

Fitch expects that fully collateralised programmes secured by standard assets should be able to generate a good level of recoveries and will be eligible for a one-notch recovery uplift in all rating scenarios.

Programmes with OC that offsets at least stressed credit loss levels implied by Fitch’s static model output will, meanwhile, be eligible for a two-notch recovery uplift, or three notches if the tested rating on a probability of default (PD) basis is non-investment grade.

The assigned recovery uplift may, however, be one notch lower if Fitch identifies material downside risks to recovery expectations.

Also included in Fitch’s proposals are new refinancing spread level (RSL) assumptions for mortgage and public-sector cover pools – which are used in the rating agency’s cashflow modelling – to make them more comparable between asset types and jurisdictions.

Fitch said this revised approach generally results in substantially lower RSL assumptions for public-sector assets in countries rated A or lower, following the removal of certain credit risk premiums embedded in the peak observed spreads.

For example, Fitch said the AA RSL for Italian sovereign bonds would decline from 830bp to 300bp and the A RSL for Portuguese sovereign bonds would fall from 1500bp to 500bp.

But Fitch said that sovereign RSLs proposed for some countries in the high-investment-grade category are higher as a result of a qualitative overlay assessment, particularly in those countries without reserve currency flexibility or with a small-sized sovereign bond market on a relative basis. AAA sovereign RSLs for most Nordic countries would increase from 60bp to 100bp, for example.

Fitch said it tested the proposed changes on a sample of 68 of the 130 covered bond programmes it publicly rates. Out of this sample, 23 programmes are likely to be upgraded and 10 likely to be downgraded, it said.

The possible upgrades are mainly from the low-investment-grade countries of Italy, Spain and Ireland and the sub-investment-grade counties of Portugal and Greece, while upgrades are also considered likely among UK programmes not already rated AAA. The magnitude of upgrades is limited to one rating category, it added, with the exception of one Italian programme, which could be upgraded by five notches. The main drivers of these upgrades are either higher IDR uplifts, higher PCUs, or a combination of the two.

Fitch said the 10 programmes that would be likely to be downgraded are all in high-investment grade countries, and said these downgrades would likely be limited to one or two notches.

Two programmes would be affected by the removal or lowering of the IDR uplift as their issuers have support-driven IDRs; two are programmes that Fitch deems more at risk of undercollateralisation in the event of resolution; and one would be downgraded due to the removal of the recovery uplift due to a combination of currency mismatches and OC constraint.

A further five programmes could be downgraded due to the new recovery approach as the breakeven OC for their rating, which would be based on a higher tested rating on a PD basis, would be higher than the OC currently relied upon by Fitch in its analysis.

The rating agency deals with multi-issuer cédulas hipotecarias separately and said that about half of its 24 ratings of these such issuance could be upgraded by one notch.

Among the remaining 62 programmes not tested, Fitch does not expect further upgrades, as all non-AAA rated programmes that could be upgraded due to the combined proposals were included in the sample.

The rating agency added that the proposals could lead to an increase of the breakeven OC for the current rating of some programmes that have not been formally tested. However, it said further OC-related downgrades are unlikely, because many programmes maintain a higher OC than the breakeven OC for their current rating and issuers can generally increase collateral.

Fitch is requesting feedback from market participants on the proposed amendments, with the deadline for submissions 29 July. Following the review period and consideration of responses received, Fitch expects to finalise and publish the criteria in the third quarter of 2016.

Overview of Covered Bond Rating Steps

PCU: Payment Continuity Uplift; OC: Overcollateralisation; PD: Probability of default; RU: Recovery Uplift

Source: Fitch