Seven Italian covered bond programmes are at risk of being downgraded by Moody’s should the rating agency downgrade the Italian sovereign, which is now on review for downgrade. However, analysts say the regulatory impact of any such downgrades should be limited, while spreads are seen more linked to political headlines.

Moody’s placed Italy’s Baa2 rating on review for downgrade last Friday. The move was not because of the political developments of recent days, but by the rating agency’s view that the fiscal policies put forward by parties seeking to form a coalition government risk a material weakening in Italy’s fiscal strength. Moody’s also cited the risk that structural reform efforts could stall and past reforms could be reversed under the next government.

“Moody’s will use the review period to assess the impact of the fiscal and economic policy platform of the new government on Italy’s credit profile, with a particular focus on the effect on the deficit and debt trajectories in the coming years,” it said.

Negotiations to form the coalition government broke down after Moody’s announced the review for downgrade – triggering a sell off in Italian government bonds on Tuesday as markets feared a new election would raise the risk of Italy exiting the Eurozone – but talks resumed on Wednesday and the new government is set to be sworn in today (Friday).

Following Moody’s announcement, analysts flagged that Italy’s country ceiling and individual bank ratings are also at risk of downgrades.

“This could pull many OBG ratings along as they are either located at the Aa2 country ceiling or have no more TPI leeway left,” said analysts at Commerzbank.

Moody’s currently rates seven Italian covered bond programmes at the country ceiling of Aa2 – those of BPER Banca, Cariparma, Credito Emiliano, Intesa Sanpaolo, UBI Banca and UniCredit (which has two Aa2 rated programmes, one soft bullet and one CPT).

Should the sovereign be downgraded and the country ceiling consequently lowered, analysts noted that these seven programmes would be downgraded.

Bernd Volk, head of covered bond and SSA research at Deutsche Bank, suggested the market impact of a one or two notch downgrade for these covered bonds would be limited.

“Given the market is dominated by Italian politics and geopolitical risks, at least at these current high rating levels, the direct impact of potential covered bond rating downgrades on spreads seems limited,” he said. “In case of negative political headlines, the market will likely widen, even without a downgrade.

“The main risk seems that downgrades could come at the worst possible time, i.e. feeding right into already available negative headlines and market sentiment.”

Analysts also said the potential downgrades should have only a limited on the bonds’ regulatory treatment.

“The only good news in this context would be that such downgrades should not affect regulatory thresholds in most cases,” said Commerzbank analysts.

Deutsche’s Volk added that core euro area banks usually do not hold covered bonds as LCR assets and suggested that Italian banks prefer to hold higher yielding sovereign bonds.

Moody’s rates five other Italian covered bond programmes, four of them at A1 – two Banco BPM mortgage-backed programmes, a Banca Monte dei Paschi di Siena mortgage programme and an Intesa Sanpaolo public sector programme – and a Banca Carige mortgage programme at Baa1. The four mortgage-backed programmes have no notches of TPI Leeway, according to analysts, and the covered bond ratings would therefore be vulnerable if the respective issuers are downgraded.

On the back of the review on the sovereign rating, Moody’s on Wednesday afternoon took rating actions on 12 Italian banking groups, including placing on review for downgrade the counterparty risk (CR) assessments of nine institutions – including OBG issuers Intesa Sanpaolo, Banca IMI, Cariparma, Credito Emiliano and UniCredit.

Moody’s also placed on review for downgrade the issuer and/or senior unsecured ratings of four banks, none of which issue Moody’s-rated covered bonds.

OBG spreads widened substantially across the curve in May. The smallest moves were at the short end, with three year OBGs widening by around 25bp versus their German counterparts, and the largest at the long end, with 10 year OBGs widening by 32bp, according to figures from NordLB analysts.

“In our view, these developments have to be seen as a clear consequence of the rising risk premiums which market participants are demanding for Italian covered bonds,” said Matthias Melms, head of covered bond and SSA research.

Much of the widening took place this week, amid the Italian sell-off. Analysts noted that OBGs have performed significantly better than Italian government bonds in recent days, and attributed this to covered bonds’ strength and, more specifically, to OBGs’ solid fundamentals.

“Thanks to their fundamentally good quality, Italian covered bonds can gain an advantage over the country’s sovereign bonds, which will feel the greatest impact of the ‘Italy first’ and ‘deficit last’ policy if the situation escalates,” said Alfred Anner, senior covered bond analyst at BayernLB. “In this scenario, covered bonds would be more than likely to continue to outperform – as they have already done in recent weeks.”

The widening pressure was far greater in Italy than in other market segments last month, although other peripheral markets were affected – with Spanish covered bond spreads widening by an average of around 14bp and Portuguese by around 9bp in May. Core covered bond spreads widened only slightly.

Photo: New Italian prime minister Giuseppe Conte enters the Quirinal Palace.