Rating agencies expect the European Commission’s proposals to harmonise EU covered bonds to have a generally positive impact, welcoming in particular mandatory liquidity buffers and clarity on maturity extensions, but Spain is among countries and issuers facing change.

On 12 March, the European Commission unveiled its long-awaited proposals for a Directive, aimed at providing a common definition of covered bonds and defining the features of and rules applying to covered bonds seeking to use the new “European Covered Bond” label, and a proposed Regulation, aimed at strengthening conditions for granting preferential capital treatment for covered bonds through the introduction of further requirements.

Moody’s, Fitch, S&P, DBRS and Scope state that the proposed Directive and Regulation will be generally positive for covered bonds, variously highlighting that it will raise and maintain standards, provide greater certainty to investors and encourage the development of covered bond markets.

“The legislative proposal is credit positive because it will introduce mandated minimum credit standards for EU countries’ national covered bond legal frameworks,” said analysts at Moody’s. “The minimum standards will provide a template for the development of covered bond legal frameworks in EU countries where such frameworks are being materially revised and improve legal frameworks in cases where national standards are less comprehensive than the proposed EU standard.

“For countries with well-established covered bond markets that already have high legal standards in place, such as Germany and France, the proposed minimum standards will in some cases embed additional protections for covered bond investors into law.”

Rating agencies said the proposals are also well balanced, having taken into account market participants’ feedback, and should generally avoid disruption of well functioning markets.

“The Commission undertook an extensive consultation process, so what came out is ultimately a mutually-agreed solution,” said Karlo Fuchs, head of covered bonds at Scope. “Everybody saw this coming; the lawyers have just been waiting to get their pencils out to start amending existing laws to achieve compliance.

“In that respect, the proposals are a feast for lawyers but not necessarily the market.”

Liquidity buffer brings potential

Fitch highlighted the introduction of a mandatory 180 day cover pool liquidity buffer, covering interest and principal payments, as being the main positive in the Directive.

“The Directive describes liquidity protection as a key structural feature of covered bonds, which is consistent with Fitch’s view that liquidity is crucial for timely payment after an issuer default,” it said.

In practice, most mortgage covered bond programmes have longer protection through a 12-month extension for principal payment, according to Fitch, which noted that around 80% of the 111 covered bond programmes it rates as at the end of February had a payment continuity uplift of four or more notches due to the liquidity protection in place.

“If the Directive is adopted in its current form, the potential impact would therefore be largest in a few countries where the absence of liquidity protection limits our capacity to rate covered bonds well above the issuing bank’s Issuer Default Rating, such as Spain and Austria,” it said.

“In Spain, for example, there would be strong potential for rating uplift for Fitch-rated covered bonds because hard-bullet Spanish programmes currently lack specific mechanisms to bridge temporary liquidity shortfalls after recourse to the cover pool is enforced. The extent of any uplift would depend on the liquidity mechanism implemented by Spain’s national authorities in response to the Directive, and the level of overcollateralisation available.”

Each of the other rating agencies also cited the liquidity buffer as a positive introduction. DBRS said the application of the measure could translate, for example, into a better LSF assessment for certain Portuguese conditional-pass through (CPT) programmes.

S&P noted that to determine the required principal, the extended maturity date may be considered, meaning principal repayments on soft bullet covered bonds are excluded from the calculation. It also notes that other requirements imposed at the issuer level, such as assets used in the liquidity coverage ratio, may be taken into account for the calculation at the local regulator’s discretion.

“From our perspective, however, where the liquidity buffer is located at the issuer level, it is unlikely we would give credit to it in our analysis for covered bonds,” they said. “In contrast, where the issuer has committed to fund a reserve under a prematurity test, we typically incorporate this form of support in our analysis, provided such provisions are in line with our applicable counterparty risk criteria.”

Collateral fears may be overdone

The proposed package replaces the current definition of covered bonds provided by the UCITS Directive. As part of its rules on what can constitute a covered bond, the proposed Directive requires that covered bonds are at all times collateralised by “high quality assets” meeting certain criteria. Some market participants have expressed concern that this could allow the use of riskier types of collateral than the traditional mortgage and public sector loans.

Moody’s said the requirement of “high quality assets” is credit positive, but said the lack of definition of what is “high quality” will likely create some ambiguity.

S&P said the wording of this unexpected provision reflects the balancing act done by the Commission, and believes market participants’ concerns “may be overdone”, noting that the Commission has acknowledged the risks of non-traditional assets like SME and infrastructure loans.

“Stealthily including such asset types in the Directive would have run counter to the consultation process initiated with the industry and the EC’s light touch approach,” they said. “We nevertheless believe the wording about additional high quality assets should be dealt with by the EC or the European Parliament later in the process to clarify the scope of the Directive about eligible assets.”

Maturity extension clarity positive, OC impact limited

Rating agencies also welcomed the clarification that any maturity extension of soft bullet and conditional pass-through (CPT) covered bonds cannot be triggered at the issuer’s discretion and must be regulated by law or contract, among other conditions, including that bankruptcy remoteness and recourse to the issuer must not be affected by an extension.

The treatment of soft bullet and CPTs had been flagged by market participants as a potentially controversial aspect of harmonisation, in responses to recommendations from the European Banking Authority, which informed the Commission’s proposals.

“DBRS notes that the EBA recommendation to this respect has, in substance, been turned down,” Vito Natale, head of covered bonds and surveillance at DBRS, told The CBR. “The EBA was recommending that the covered bond extension only be effected upon the covered bond Issuer being defaulted.

“The Directive may therefore turn out being a saving grace for Danish covered bonds, which would have been the most disrupted by the EBA recommendation.”

The proposed Regulation includes the introduction of a new minimum overcollateralisation (OC) requirement of 2% or 5%, depending on the assets’ valuation model.

Fitch said this principle is unlikely to address all credit and market risks in covered bond programmes. The rating agency notes that all programmes it rates have a nominal OC above 5% and, in most countries, the weighted-average nominal OC as at 1 January ranged between 20% and 60%.

“Market practices therefore provide greater investor protection than the nominal principle, and we think issuers will maintain them for this reason,” said Fitch analysts.

Spanish challenges highlighted

S&P and DBRS flagged that a lot of work will be required in Spain in particular to align national regulation with the proposals.

S&P suggested two changes in particular could prove detrimental to holders of Spanish cédulas: that a cover register would reduce assets available, given bondholders at present have a claim over all mortgage assets; and that the current legal OC level of 25% could be reduced.

“The situation is compounded by the large number of programmes and covered bonds outstanding, and the high importance of covered bond funding for Spanish banks,” they said.

Moody’s noted that Spain and Austria – two countries where legislative upgrades have been long awaited – have already indicated that they will update their frameworks to follow the new pan-European standards.

S&P analysts also highlighted that restrictions on mixed pools, while likely to have a limited overall impact, could affect the covered bond programme of Compagnie de Financement Foncier, which is backed by both mortgage and public sector loans.

“We expect the issue to be addressed at national level, depending on the stance taken by the French regulator and on the transposition of the Directive into local law,” they said.