“Strongman leaders” and bank controversies are potential key sources of headline risk in 2019, rating agencies have warned, but although some consequences could prove negative for covered bond credit quality, the asset class is expected to remain resilient and even benefit.

Moody’s said that while the regulatory and market environment will remain supportive for covered bonds in 2019, risks are emerging, with the possibility of a no-deal Brexit and the rise of anti-consensus political movements posing potential concerns.

While it expects an arrangement to be reached between the UK and the EU to preserve many existing arrangements, it said the probability of a no-deal Brexit has risen in recent months.

“Such an outcome would be negative for UK covered bonds because it would be negative for the UK economy and UK banking sector,” said Moody’s. “A no-deal scenario would also raise specific issues for both UK and non-UK European covered bonds.”

The rating agency goes on to say that anti-consensus political movements could threaten the broader European environment in which covered bonds have prospered, undermining the consensus necessary for policymakers to agree institutional reforms.

“Populist political movements could also foster new credit risks in cover pools,” it adds, “for example if politicians decide to be more accommodating to borrowers in times of stress.”

Scope echoes Moody’s broader concerns, warning that rather than underlying economic developments, “populist and nationally-focused strongman leaders” will move markets. However, the rating agency notes that in such an environment the stable credit profile of covered bonds should make them a preferred investment.

Fitch also points out that although the country with the most immediate headline risk – the UK – is the only sovereign on negative outlook among countries where it rates covered bonds, the 11 programmes it rates are on stable outlook.

“UK covered bonds’ relative insensitivity to the effect of Brexit is because issuers’ ratings can withstand a moderate deterioration in their operating environment and most UK covered bonds have a cushion against their issuer’s downgrade,” said the rating agency. “In addition, issuers maintain large OC (overcollateralisation) buffers that could mitigate an increase in credit or refinancing risks for the programmes.”

The three aforementioned rating agencies all forecast stable ratings for covered bonds. Of 110 programmes Fitch rates, for example, 90.9% have a stable outlook, 7.3% a positive outlook, and only 1.9% have a negative outlook or are on Rating Watch Negative.

Scope notes that the bank ratings supporting triple-A ratings for the asset class are stable and in places improving, although it notes that conduct and governance-related events – such as loose anti-money laundering controls and tax fraud – could result in headline risk and even rating pressures.

The European Central Bank’s anticipated measures are central to any 2019 forecast and, according to Moody’s, interest rates will increase at a modest pace next year as the ECB gradually unwinds the stimulus provided under its quantitative easing policy.

“Overall, we expect this market environment of gradually rising rates to be supportive for European banks and therefore their covered bonds,” it said. “However, the possibility of a sharp and sudden rise in interest rates is a risk, particularly for banks in countries with high levels of debt.”

Regulatory developments and notably the EU covered bond harmonisation package are expected to be supportive of covered bond credit quality in 2019 (as covered widely already in this publication). However, Moody’s notes that some of the credit consequences will depend on choices to be made at the national level.

Scope expects a “race” between countries to become the first fully harmonised jurisdiction and to issue the first Premium Covered Bond, with the first such transactions appearing at the end of the year.

Norwegian and Canadian covered bonds should benefit from an IDR uplift of two notches at Fitch, increasing their buffer against issuer rating downgrades, thanks to the implementation of senior debt bail-in in their resolution framework this year.

Note: Fitch, Moody’s and Scope have all published special 2019 outlook covered bond research, whereas DBRS and S&P have not yet done so.