Czech covered bonds issued by UniCredit Bank Czech & Slovakia were cut from Aa2 to Aa3 by Moody’s today (Monday) after being converted to be governed by a revised legal framework that the rating agency says increases uncertainty on unsecured claims.

The revised Czech covered bond law took effect in January 2019 and outstanding covered bonds continue to be governed by the old law unless issuers convert them to the new law, Moody’s noted in a sector comment on 3 June. It said it expected new covered bond issuance this year under the revised law as well as the conversion of some outstanding bonds.

Although the rating agency said the revised law addresses some key credit weaknesses of the previous framework, it highlighted that the revised law increases uncertainty about whether covered bondholders will benefit from a post-insolvency unsecured claim against the issuer if cover pool assets are not sufficient to repay covered bonds.

Moody’s cited this issue when downgrading the UniCredit subsidiary’s covered bonds from Aa2 to Aa3 today.

“Under the revised framework, the unsecured claim is limited to over-indebtedness (calculated by comparing the nominal value of cover pool assets to outstanding covered bonds) established within two months of bankruptcy,” it said. “Therefore, covered bondholders may be unable to register unsecured claims for over-indebtedness that arises beyond the two month registration period or for shortfalls resulting from market risks.

“Moreover, in certain circumstances, the revised framework requires covered bonds, and consequently any registered unsecured claim, to be written down.”

In its sector comment, the rating agency noted that there are some limited protections: the Czech regulator must consent to the proportionate decrease, based on the interests of covered bondholders; and covered bondholders also have a veto – although Moody’s said their interests might not be fully aligned.

The EU covered bond directive could also lead to a review of the way the unsecured claim is treated, Moody’s added.

Features of the revised law that strengthen the country’s framework, according to Moody’s, include:

• a minimum OC requirement of 2% on a nominal basis, which is in line with a number of other European covered bond laws;
• legalising issuers’ use of derivatives to hedge interest rate and foreign currency mismatches, which gives issuers a further option to address these risks;
• a requirement that an independent cover pool administrator take control of the cover pool following an issuer default, which protects covered bond investors against conflicts of interest between the cover pool and the issuer’s bankruptcy estate.

“Some weaker credit features of the previous law remain,” added Moody’s, “including a high loan-to-value (LTV) threshold and no tests to manage interest rate or currency mismatch risks or address liquidity risks.”

Moody’s assigns a Timely Payment Indicator (TPI) of “improbable” to UniCredit Czech & Slovakia’s framework, but does not disclose an issuer rating for the entity or TPI leeway for the programme.