Covered bond ratings are expected to remain stable and credit strength strong in 2018, according to rating agencies’ forecasts, with regulation supportive – as demonstrated by peripheral tests this year, collateral improving, and the European harmonisation push bringing benefits.

This year has, like 2016 before it, proved a period of relative stability for covered bond ratings, thanks to factors including regulatory treatment, central bank support and stability in country and issuer ratings.

Moody’s said in an outlook report that covered bonds’ credit quality will remain strong in 2018, underpinned by positive regulatory developments, the ongoing support of issuers, and the mostly stable credit profiles of countries in which covered bonds are issued.

Regarding Europe, the rating agency highlights that efforts to harmonise covered bond laws will maintain the preferential regulatory treatment enjoyed by the asset class, at least for covered bonds that meet the new standards. The European Commission will in March present its proposed Directive to create an EU covered bond framework, with changes expected to take force in mid-2019.

According to Moody’s, harmonisation will support the continued depth and liquidity of covered bond markets, which it deems a credit positive, as it reduces refinancing risks for the sector.

“However, some aspects of the harmonisation process pose challenges that may have adverse credit implications for European covered bonds,” said the rating agency.

It highlights that proposals to permit maturity extensions only in the event of an issuer default “raise operational and timing issues” that could increase the risk of non-payment on some soft bullet and CPT covered bonds.

“In addition, the various proposals that have been made on how to achieve harmonisation appear to combine resolution and insolvency, but these are distinct processes with different implications for covered bond credit quality,” said the rating agency.

The credit strength of covered bonds within the EU will also continue to be supported by the Bank Recovery & Resolution Directive (BRRD), said Moody’s, noting that the regulation was put into use in June, when Banco Popular Español was entered into resolution and sold to Banco Santander. The covered bonds of Popular were transferred to Santander and their credit quality was thereby improved, prompting Moody’s to upgrade them from A2 to Aa2.

“We expect the funding of entities in resolution will be a focus in 2018, following changes to the ECB’s monetary policy framework in 2017,” added the rating agency. “The changes to the ECB framework raise questions as to whether central bank liquidity would be available to covered bonds in a bank resolution or insolvency in the Eurozone.”

A gradual tightening of the ECB’s monetary policy is expected to result in an orderly increase in European covered bond yields and mortgage interest rates next year somewhat, complementing measures introduced in many European countries in 2017 to curb growth in household indebtedness, said Moody’s.

The rating agency’s outlook is similarly rosy elsewhere, forecasting that in all countries in which it rates covered bonds, covered bond credit quality will be supported by issuers’ credit strength and stable sovereign outlooks. It cited new measures introduced in South Korea to curb growth in riskier mortgages as being likely to have a positive impact on the quality of cover pools in 2018, and similarly highlighted improving mortgage collateral in Australia and New Zealand.

The rating agency also name-checked Brazil, expecting that the country’s recently finalised legal framework will be inaugurated by the first Brazilian covered bond issuances in 2018. It said covered bonds will provide important medium and long term funding for Brazilian banks, which up to now have relied on savings deposits to fund residential mortgage lending.

In its 2018 outlook, Fitch states that stability “dominates” covered bond ratings, noting that of the 110 covered bond programmes it rates, 90.9% have a stable outlook. Of the rest, 7.3% are on positive outlook or Rating Watch Positive and 1.8% are on negative outlook or Rating Watch Negative.

“The dual-recourse nature of covered bonds, regulatory and supervisory oversight, favourable position in a resolution scenario and strong liquidity provisions for most of the programmes rated by Fitch contribute to the stable sector outlook,” said the rating agency. “These lead to a significant uplift and therefore buffer (three notches on average) before a downgrade of the bank’s long term IDR would lead to a downgrade of the covered bonds’ rating, unchanged since an update of our covered bonds rating criteria in the third quarter of 2016.”

Covered bond ratings’ sensitivity to changes in issuer or sovereign rating actions is relatively limited, as 20 programmes are rated at their maximum uplift level and are therefore responsive to positive or negative bank Issuer Default Rating (IDR) movements, while it would take “extreme negative events affecting sovereign ratings, particularly the country ceiling”, to change the rating agency’s view on the covered bond sector outlook.

The UK is the only sovereign on negative outlook among the countries in which Fitch rates covered bonds, but the rating agency noted all 11 UK covered bonds programmes rated by Fitch are on stable outlook, are cushioned against any issuer downgrades, and are backed by large OC buffers.

The outlooks for the housing and mortgage markets in countries boasting Fitch-rated covered bond programmes are seen broadly stable.

“However, due to the build-up of potential stresses Fitch closely follows housing markets in countries including Australia, Canada, Norway, Sweden, Denmark and the UK,” it added.

Fitch also sees the implementation of senior debt bail-in in Norway and Canada in 2018 as being positive for covered bonds, and highlighted the potential introduction of rules on liquidity as part of the European Commission’s harmonisation efforts would be rating-positive for covered bonds in countries such as in Austria, Hungary or Spain, where liquidity protection is weak or absent.

Scope predicts that 2018 will provide more of the same for covered bonds – “but better”. The rating agency notes that its covered bond ratings are all focussed in the highest rating categories, AAA and AA+, and all have stable outlooks.

“On the back of supportive economic and bank fundamentals, credit quality in the covered bond market is not likely to change, and we have seen another year of meagre, or even negative, spreads,” it said. “Even more so, continued supply-demand imbalances have almost fully taken out spread differentiations within and, more importantly, across countries, and most covered bonds currently trade at five-year lows.”

Scope, too, sees the positives in EU covered bond harmonisation, foreseeing a fall in diversity and complexity in European regulations in spite of a principles-based approach being adopted and national regulators having the ability to maintain national discretion – though it expects tangible benefits to come from 2019 onwards.

The rating agency notes some uncertainty in the approach of the ECB towards the covered bond market, stating that the central bank has become a “de facto regulator for this segment”.

It cited the introduction of new rules on cover pool reporting in 2017 as being positive and enhancing transparency, but said more fluid communication between the ECB and market participants would support smoother implementation of their guidelines.

“Similarly, on 20 November the ECB adopted new requirements for CPT programmes, effectively making them only ‘sunshine’ collateral,” said the rating agency. “The ECB will no longer accept such CPT covered bonds for CBPP3 once a bank has become non-investment grade.

“To some extent we see this as an inconsistent development. The ECB itself would still accept pass-through securitisations (which a CPT effectively becomes upon a borrower default and where the issuer is not rated in the first place) and even a hard or soft bullet covered bond – for which the issuer would have to more significantly encumber its balance sheet.”

2017 has featured only “a very limited number” of rating actions on banks issuing covered bonds, Scope said, with forward-looking ratings position most covered bond issuers in the single A or low AA range.

S&P and DBRS had not published a 2018 covered bond rating outlook at the time The CBR went to press.