UK covered bonds should remain triple-A in spite of Brexit, according to analysts, given that most have sufficient leeway to absorb issuer or sovereign downgrades, although an unfavourable exit could put some, such as RBS’s, at risk. Meanwhile, sterling covered bonds could prove interesting.

Following the UK’s vote to leave the EU in Thursday’s referendum, Standard & Poor’s and Fitch downgraded the UK on Monday, from AAA to AA and AA+ to AA, respectively, both on negative outlook.

Moody’s on Friday changed the outlook on its Aa1 rating to negative, before yesterday (Tuesday) changing its outlook on 12 UK banks and building societies – 10 from stable to negative and two from positive to stable.

“We expect lower economic growth and heightened uncertainty over the UK’s future trade relationship with the EU to lead to reduced demand for credit, higher credit losses and more volatile wholesale funding conditions for UK financial institutions,” said Laurie Mayers, associate managing director at Moody’s.

Analysts said that the ratings of most UK covered bonds should be resilient to any downgrades of the respective issuers, citing in particular high buffers against issuer downgrades, especially in ratings from Moody’s and S&P.

They noted that UK programmes rated by Moody’s enjoy some of the highest Timely Payment Indicator (TPI) leeways in the market – of up to six notches in the case of HSBC and up to five notches for more active issuers Abbey and Nationwide – while Moody’s sovereign ceiling is the highest of the three rating agencies.

“We are quite relaxed about Moody’s,” said Florian Eichert, head of covered bond and SSA research at Crédit Agricole.

Analysts noted that in March Moody’s indicated that in the event of Brexit it could reconsider assigning a notch uplift to UK covered bonds that stems from their preferential treatment under the Bank Recovery & Resolution Directive (BRRD).

“However, given the high TPI Leeways of most UK covered bonds, solid fundamentals and high levels of OC (overcollateralisation), we do not foresee any immediate rating changes to UK covered bonds,” said analysts at Société Générale.

In the case of S&P, analysts said covered bond ratings are also well protected, and highlighted that the rating agency may not necessarily downgrade issuers in the short term.

S&P on Friday said that the leave vote has no immediate impact on its ratings of UK domestic commercial banks, because it does not include government support in its UK commercial bank ratings. It said that unused notches of uplift means that a sovereign downgrade of up to two notches would not in and of itself directly affect its UK covered bond ratings.

“As such, any changes in the UK sovereign credit rating would not automatically affect such ratings,” it said.

S&P added that the vote will also not directly affect its credit analysis of the underlying collateral backing UK covered bonds, and that a possible depreciation of sterling will not, in its view, alter the capacity of covered bond issuers to meet their payment obligations.

However, analysts noted that Fitch’s UK covered bond ratings have the lowest leeways of the three rating agencies, and said the ratings could be negatively affected.

“In case of Fitch, it is noticeable that only four issuers can rely on an unused rating buffer of more than one notch while four covered bond programmes do not have a rating buffer at all,” said Michael Spies, covered bond and SSA strategist at Citi. “And here, we think that rating pressure even occurs for some UK covered bonds.”

Spies said this is exemplified by RBS’s issuer rating of BBB+, on a stable outlook. RBS’s covered bonds have no unused notches of rating uplift from the issuer rating under Fitch’s analysis.

Fitch has previously highlighted, however, that it only expects pressure on UK bank ratings in a scenario which sees the UK leave the EU on unfavourable terms, and/or a subsequent vote by Scotland to leave the UK.

“To us these statements mean that for now we should not expect an immediate reaction,” said Eichert, “and only should we see Fitch’s unfavourable scenario and/or a Scottish vote for independence occur could banks move down.”

Analysts said that in this scenario, RBS’s AAA ratings would be the most vulnerable. Lloyds Building Society and Yorkshire Building Society also have no unused notches of uplift.

Meanwhile, Citi analysts noted that the triple-A rated sterling market became substantially smaller in the wake of Monday’s downgrades of the UK sovereign, with other asset classes more vulnerable than covered bonds.

They suggested this could make UK sterling-denominated covered bonds, which on average offer a pick-up of 80bp versus Gilts, an attractive alternative for investors that require triple-A rated paper.

“In the longer term, it remains to be seen how the political gridlock within the UK and between the EU and the UK will eventually be resolved,” Spies added. “Further sovereign downgrades could increase the pressure on issuer ratings and indirectly on covered bond ratings while permanent political uncertainty can obviously drag the country’s economic growth, potentially again a credit negative for the UK banking system.”

Photo: UKIP leader Nigel Farage; Source: European Union 2016 – European Parliament