Covered bond ratings are expected to remain stable in 2017, with rating agencies citing stable sovereign and bank outlooks and supportive regulation – including harmonisation efforts – as underpinning credit quality, although some see potential for downgrades of Italian programmes.

In 2016 covered bond ratings have enjoyed a period of relative stability, owing to the product’s privileged regulatory treatment, central bank support and a lack of issuer downgrades – and rating agencies are united in expecting the good times to continue in 2017.

“In their outlooks for 2017, the rating agencies seem to agree on one point: the prospects for the ratings of covered bank bonds are not bad at all at the moment,” said Jörg Homey, head of covered bond research at DZ Bank.

In an outlook report on European ratings, Moody’s said the credit quality of covered bonds will remain strong next year, due to supportive regulation – including the European Commission’s efforts to harmonise covered bond frameworks – and stable outlooks on underlying sovereigns and banks.

“We expect the harmonisation of the various covered bond legal frameworks across Europe to take shape in 2017,” said Moody’s. “This harmonisation process, which is likely to involve the setting of minimum standards for covered bond legal frameworks, should underpin continued regulatory support for European covered bonds, which is credit positive.”

The rating agency said there is a risk that some covered bonds may not meet the new harmonised standards, however, and said this could result in them losing preferential treatment under EU laws.

Moody’s said the implementation of the BRRD across the EU will continue to support the credit quality of European covered bonds, having already resulted in a lower expectation of default for many programmes, but said proposed MREL requirements could be credit negative for the covered bonds of certain issuers.

“Some small banks’ MREL requirements may be set at a level that would only cover the capital needed for an insolvent liquidation,” it said. “This could be credit negative for covered bonds issued by these banks because it would increase the likelihood that if the bank failed, its covered bonds would remain with an insolvent entity.

“The risks for covered bonds that are associated with insolvent liquidation can be avoided if the covered bonds are transferred to a third party or remain with a resolved entity that is a going concern.”

The rating agency expects covered bond issuers to issue more longer-dated covered bonds in 2017, in order to price deals at positive yields in the prevailing low or negative yield environment, and said this will improve the asset-liability matching of European covered bond programmes – another positive.

“The low and negative interest rate environment also entails risks, however,” said Moody’s. “While it has supported the recovery of some European economies, it has also fuelled property markets and mortgage lending in other countries, driving up already high levels of household indebtedness.”

Many European countries implemented or proposed measures to limit mortgage debt this year, and Moody’s expects authorities to continue their attempts to curb credit growth and house prices in 2017.

The rating agency said that the trend towards soft bullet and conditional pass-through issuance, which it expects to continue in 2017, will also lower issuer’s refinancing risk.

Fitch expects a greater stability in covered bond ratings next year, noting that of the covered bond programmes it rates, some 92% have a stable outlook, 5% are on negative outlook or Rating Watch Negative, and 3% are on positive outlook.

Fitch said its stable outlook for the sector is influenced by the rating agency’s updated methodology. Fitch revised its covered bond rating criteria in October, resulting in an improvement of Issuer Default Ratings (IDR) uplifts for many programmes and as many as 23 potential upgrades.

Once the revised criteria are fully implemented, Fitch estimates that the maximum uplift for the covered bond programmes it rates will increase from an average of 6.2 notches to 7.4 notches, and that around 70 programmes will benefit from an IDR uplift of two notches, compared with 35 previously.

The rating agency cited other factors as supporting the stability of covered bond ratings next year, including positive regulatory developments, the decreasing influence of sovereign ratings on covered bond ratings, and generally stable bank outlooks.

Fitch’s negative outlooks on bank ratings are mainly centred in Italy, where four Fitch-rated covered bond ratings are on negative outlook.

“While three of these programmes have significant buffers against banks downgrades, their ratings are equalised with the AA+ country ceiling for Italy and the Negative Outlooks mirror that on the sovereign rating of BBB+,” Fitch said.

The rating agency expects weaker growth in the Eurozone next year, but said covered bond ratings should be unmoved by such factors.

“The potential impact from political shocks, embodied by the UK Brexit vote or the US election and the ripple effects this can have on the European continent’s crowded political calendar in 2016 and 2017, is still uncertain,” it said. “Nevertheless, it would take extreme negative events affecting sovereign ratings, particularly the country ceiling, to change Fitch’s view on the covered bond rating outlook.”

In a report published in October, Standard & Poor’s said a stable outlook on most issuers and sovereigns combined with positive – albeit slow – economic growth in the Eurozone should support covered bond ratings stability throughout 2017, adding that the percentage of its covered bond ratings with negative outlooks are historically low.

Scope also expects the credit performance of covered bonds to continue to improve in 2017, “thanks to the enhanced regulation and supervision that is strengthening European bank credit fundamentals, the anchor point for this asset class’s credit quality”.

“At the same time,” added the rating agency, “the ECB’s quantitative easing continues to support financial stability in Europe and benefits borrowers’ asset quality, and ultra-low interest rates are prompting issuers to lengthen the maturities of new covered bonds, thereby reducing their main risk – the asset-liability mismatch.”

DBRS is set to publish its covered bond rating outlook in January. Most of DBRS’s covered bond ratings are concentrated in southern Europe, and Vito Natale, head of covered bonds and surveillance at DBRS, told The CBR that the potential for downgrades of covered bonds centres around Italy.

“We have the Italian sovereign on review with negative implications, and the recapitalisation of Banca MPS is going to be a critical point for the rest of the Italian banking system,” he said. “A one-notch downgrade of the sovereign is not necessarily going to impact Italian covered bond ratings, but if you were to combine a downgrade of the sovereign and negative rating actions on the banks then it would definitely have a negative impact on covered bond ratings.

“We don’t think there is a one-to-one correlation between a sovereign downgrade and a bank downgrade in Italy, but the situation of MPS is going to pave the way for the future of the Italian banking system, either positively or negatively.”

Natale said, however, that asset quality is holding up.

“If there is any risk in Italian covered bonds it is not going to come from asset quality, it is going to come from the compounding of the potential risks coming from the sovereign and the banking system,” he said.

In Spain and Portugal, Natale said risks are “balanced” for covered bonds, noting that both sovereigns are on stable outlook.

“It looks like Portuguese banks are starting to address the risks facing them, and there is some economic recovery, although it is a bit sluggish,” he said. “It looks like ratings in the Portuguese covered bond space are going to stay where they are for now.

“In Spain, economic growth is holding up and asset quality seems to be improving. The only test lying ahead for Spanish covered bonds is the reform of the legislative framework. We cannot yet predict what the impact of that will be.”

Photo: Banca Monte dei Paschi di Siena