Prevailing low to negative interest rates mean that investors in German Pfandbriefe are being provided only limited protection by a stressed present value OC requirement set by the Pfandbrief Act, according to Moody’s, with programmes backed by commercial mortgages particularly affected.

In a sector comment published on Monday, Moody’s noted that German covered bond issuers are required under the Pfandbrief Act to maintain a minimum 2% overcollateralisation (OC) level in present value terms under pre-determined stressed interest rate scenarios, which may include scenarios where interest rates are 2.5 percentage points higher and lower than actual interest rates, in order to protect investors against changes in interest rates that reduce the present value of cover assets.

However, the stressed interest rate that is used to calculate the stressed present value cannot be less than 0% – a floor set by the Pfandbrief Act.

“In the current low interest rate environment, actual interest rates are close to 0% or even below 0%,” said Moody’s analysts. “Therefore, there is little difference between actual interest rates and the 0% rate that is used to determine the stressed present value OC requirement in a scenario of declining interest rates.

“As such, the protection offered to investors by the stressed present value OC requirement in scenarios where interest rates decline is limited.”

The rating agency said that commercial mortgage-backed Pfandbrief with high proportions of floating rate assets are the most affected, noting that German Pfandbrief programmes have on average more floating rate assets than floating rate liabilities and that interest rate risk is either not hedged or not fully hedged.

“Therefore, for the calculation of the stressed present value OC, scenarios involving a decline in interest rates determine the amount of assets needed to meet the 2% statutory OC requirement for most Pfandbrief programmes,” said the rating agency.

“While the proportion of fixed rate Pfandbriefe is high and similar across most issuers, the proportion of fixed rate assets is lowest for programmes with a majority of commercial mortgage loans in the cover pool. Therefore, the protection provided by the stressed present value OC requirement is lowest for such programmes in the current low interest rate environment.”

Moody’s covered bond ratings are not affected because it determines the level of OC consistent with the current covered bond rating on either an unstressed present value or on a nominal value basis.