2017 still holds risks for Italian covered bonds, DBRS said yesterday (Thursday), but it does not expect further downgrades to follow a recent sovereign cut, and sees a brighter picture for other peripherals. Overall, the rating agency foresees a volatile year as players adapt to “the new market order”.

In a commentary published yesterday on the rating agency’s outlook for European structured finance and covered bonds, DBRS’s forecast highlighted multiple potential flashpoints, and although the covered bond market is expected to remain stable, some segments face a more difficult year than others.

DBRS’s covered bond rating universe is weighted towards southern Europe, and it outlined risks for Italian covered bonds in particular, due to its recent downgrade of the sovereign and pressure on Italian banks.

The rating agency downgraded Italy on 13 January, from A (low) to BBB (high), and subsequently downgraded a covered bond programme of Banca Carige on Thursday of last week (19 January) from BBB (high) to BBB. On Tuesday, it announced that no further rating actions are expected as a result of the cut to the sovereign, although it said more covered bond downgrades could occur if the programmes’ respective Covered Bond Attachment Points (CBAPs) are downgraded.

“Italian banks are facing numerous challenges,” said DBRS. “These include the large stock of non-performing loans (NPLs), volatile investor sentiment and a more onerous regulatory environment.

“Against this backdrop, large parts of the banking sector will need to take further actions to reduce costs and strengthen capital levels.”

The rating agency said some banks are in a better position to cope with such challenges than others, while some such as Banca Monte dei Paschi di Siena (Banca MPS) would likely fail without external support. A Eu20bn fund announced by the government in December should, DBRS considers, reduce risks, diminish the prospects of individual banks entering resolution, and support market access for the entire banking system.

“Credit quality of Italian covered bond pools is guarded by structural features that provide for delinquent and defaulted loans to be accounted for at a lower value in the applicable coverage test; however, flat economic growth over the last decade has stalled any significant improvement in asset performances,” the rating agency added.

“Growth potential remains weak, but net household financial wealth constitutes a considerable buffer to absorb shocks.”

In Spain and Portugal, DBRS said risks appear “well balanced” for covered bonds, with the outlook stable on Spain’s and Portugal’s sovereign ratings and progress being made in tackling the risks facing both banking systems. Improvements are being made in asset quality, the rating agency noted, even though stocks of NPLs are expected to remain relatively high.

Overall, the direction of markets will continue to be dominated by global and European political headlines, DBRS said.

“Based on this, DBRS expects a volatile year in 2017,” it said. “On the political front, in March 2017, the United Kingdom plans to invoke Article 50 and the Netherlands holds its general election. In the summer, France will hold its elections and then, in the autumn, Germany will have its federal election.

“US president Donald Trump could also create volatility with his unorthodox dissemination of information and policy.”

Central banks will react to “the new market order” in contrasting ways, the rating agency added, some raising rates and others maintaining accommodative policies.

“Overall, there will be plenty of changing dynamics on the central bank front to react to the changing market in 2017,” it said.

DBRS noted that euro benchmark covered bond issuance is expected to total around Eu130bn this year – roughly in line with last year’s supply of Eu125.7bn. The rating agency acknowledged that issuance has already got off to a strong start, with over Eu25bn of supply so far this month, and said most issuance is likely to come in the first three quarters of 2017 as the ECB continues its covered bond programme.

The earliest end date for CBPP3, and the rest of the ECB’s QE programmes, is set at the end of December, and DBRS said the programme should therefore support the market through the elections in France and Germany.

“Credit differentiation is likely to re-emerge as the ECB pulls back from the market,” added the rating agency. “Peripheral European bonds are likely to widen more than core European bonds. Conditional pass-through structures are likely to widen more than bullet or soft bullet.

“An unintended consequence of QE is that traditional covered bond investors have migrated to other assets classes, diminishing the analytical attention to the sector, which could exacerbate reactions to ECB tapering.”

Photo: Assorted right wing EU politicians, including Marine Le Pen and Geert Wilders; Copyright: EU/European Parliament