Covered bond ratings will remain broadly stable in 2021, according to rating agencies’ forecasts, despite likely deterioration in cover pool asset quality and the possibility of sovereign and issuer cuts, with the implementation of the EU Directive expected to benefit a handful of jurisdictions.

Rating agencies generally agree that weakening cover pool asset quality due to the ongoing impact of Covid-19 in 2021 – including increased residential mortgage arrears and defaults as payment holidays end, and reduced commercial real estate (CRE) values – will not materially hurt the credit quality of most covered bonds due to sufficient mitigating factors, primarily high levels of available overcollateralisation (OC).

Moody’s said that as the ongoing economic fallout from the coronavirus impacts asset values and borrowers’ ability to service debt, cover pool collateral performance will worsen, but given most covered bonds benefit from high OC (mostly exceeding 40%) and cover pool mortgages generally have low LTV ratios (of around 50%), the credit quality of covered bonds will not be impacted.

“Additionally, issuers have historically provided voluntary support where necessary to prevent a deterioration in covered bond credit quality,” the rating agency added, “typically by substituting good loans for bad loans in cover pools.”

Moody’s: Weighted average OC and indexed LTV ratios for residential mortgage covered bonds in select markets

Source: Moody’s; Note: Based on available data reported between September and November 2020. Where LTVs are reported as ranges, midpoints are used in weighted average calculations. Weighted average OC for Germany excludes extreme outlier.

In its 2021 outlook, Fitch echoes this expectation, stating that OC is currently a constraint on its ratings for just four programmes, in Greece and Denmark, with the majority of its covered bond ratings protected from asset quality deterioration.

“Covered bond programmes all have a lot of OC cushion and most mortgage programmes have contractual protections such as asset coverage tests,” said Natasha Guérer, director, covered bond ratings, Fitch.

“The negative outlook on some covered bonds could remain in place for a while,” she added, “as government support to economies and borrowers is gradually withdrawn, but they won’t necessarily translate into downgrades unless the downturn is deeper or more prolonged.”

While S&P also foresees limited negative impact on prime residential mortgage loans, it finds key risks in jurisdictions where it anticipates higher unemployment, such as the UK and Spain, and in cover pools with significant exposure to borrowers who are self-employed or on temporary contracts.

The rating agency expects the performance of commercial real estate (CRE) assets to be the most severely affected by secular trends, such as the growth of home working and e-commerce. However, these generally constitute a relatively small part of the cover pools backing programmes it rates so it does not anticipate this impairing the credit quality of covered bonds to a significant extent.

Gordon Kerr, head of structured finance research, Europe, DBRS, said that while Q4 2020 growth is likely to be subdued in many countries due to the ongoing impact of the second wave of coronavirus, the recent progress made in implementing an effective vaccine means there is a lower risk of a prolonged slump in global growth into 2021.

“The expectation from our scenarios is that European unemployment rates are going to increase in 2021 before they start to recover in 2022,” he said, “but this depends on how long government measures continue to support both companies and individuals as we move into next year.”

Sovereigns less of a source of concern this time

The credit quality of issuers and sovereigns will weaken in the new economic environment caused by the coronavirus outbreak, according to the rating agencies, but in most markets where covered bonds are rated, issuers and sovereigns entered the crisis in relatively strong positions and therefore have a broadly stable outlook for 2021.

Moody’s said that while its global outlook for sovereign creditworthiness is negative, its rating outlooks for most countries in which it rates covered bonds are largely stable, with only two European mortgage covered bond markets – Romania and Turkey – on negative sovereign outlooks. Given sovereign downgrades were the primary driver for covered bond rating actions between 2008-2012, it expects covered bond credit quality to remain strong overall in 2021.

S&P similarly expects most sovereign ratings to remain stable, having placed only Spain and Slovakia on negative outlooks. Moreover, with some exceptions, it said covered bond ratings in most jurisdictions would not change in the case of a one-notch downgrade of the sovereign rating. The rating agency goes on to flag Greek, Irish, Italian and Spanish covered bonds as those most sensitive to changes in their respective sovereign ratings, as well as those backed by public sector assets in Belgium, France, and the UK.

The ratings of Cypriot, most Italian and one Greek covered bond programme are most at risk from a weakening in sovereign credit profiles via an increase in sovereign indebtedness, according to Fitch. However, it deems this unlikely given all three jurisdictions’ issuer default ratings (IDRs) are on stable outlook, with only one covered bond rating from Panama on negative outlook.

“Country ceilings are not a direct threat to these ratings, as evidenced by the stable outlooks on Cyprus, Greece and Italy’s IDRs,” the rating agency said.

Regarding Brexit, Fitch predicts the impact on UK covered bond ratings to be limited, even assuming UK-EU trade moves to WTO terms and significantly curtails the pace of UK recovery in 2021.

“Excluding one programme rated A/RWN, UK covered bonds’ AAA ratings can sustain between three to five notches of IDR downgrades, and substantial OC cushion provides protection against performance deterioration,” it said.

DBRS’s Kerr said the risks posed by Brexit coupled with the effects of the pandemic has led to increased uncertainty over the economic impact that will be felt in both the UK and EU.

“Normally, we would have seen a prospect of a dip in both economies as they’re both fighting the pandemic,” he said. “In terms of recovery out of it, Brexit creates even more uncertainty in how this will impact them and discern which impacts are from Brexit and from Covid.”

The impact of a hard Brexit could be relatively severe, added Kerr, although he said that given there has been a long lead time, many businesses will have put preparations for such a scenario in place already.

“We do not know whether we will have a deal come the end of the month, so I think it’s a case of people crossing their fingers and hopefully being prepared for the worst case scenario either way,” he said.

Buffers protect against bank downgrades

Rating agencies’ banking outlooks for 2021 are broadly negative, with most banks expected to be impacted to some extent by deterioration in asset quality due to the economic fallout from the pandemic.

However, the majority of covered bonds still have a buffer protecting them from a downgrade in the respective issuer ratings.

Moody’s outlook is negative for 75% of countries where it rates banks, but the proportion of covered bond issuers with stable outlooks has remained high – nearing 80% – albeit declining slightly from 2019.

“In most countries where we rate covered bonds, banks entered the coronavirus crisis with significantly higher capital and liquidity than at the time of the 2008 financial crisis,” they said. “This strong starting position will help banks with the inevitable asset quality and profit deterioration as loan delinquencies increase because of the economic consequences of the pandemic.”

Andrew South, head of structured finance research, EMEA, S&P, said that most of the covered bonds it rates could comfortably withstand a downgrade of the issuer without the programme rating being lowered.

“French and German programmes are generally better protected in this respect,” he said. “Spanish and Italian programmes, on the other hand, typically have less of a buffer to mitigate the effective issuer downgrade, and could also be directly affected if the sovereign rating were to be lowered.”

S&P: Unused notches by country

Source: S&P; Note: Unused notches are the number of notches the issuer credit rating can be lowered by, without resulting in a downgrade of the covered bonds, all else being equal. Data from: Global Covered Bond Insights Q3 2020, 17/09/20.

Fitch meanwhile said the breakeven OC for AAA covered bond ratings for some issuers in Belgium, Canada, France, Germany, Switzerland and the Netherlands rated A+ or AA- on negative outlook would increase if the issuer is downgraded by one notch.

The rating agency has placed most Spanish and Portuguese banks on negative outlook, corresponding with negative outlooks on most cédulas and obrigações hipotecárias (OH) ratings, which are sensitive to any downgrade of bank long term issuer default ratings (IDRs) as they have zero notches of buffer against IDR downgrades.

Directive benefits anticipated, issuance shift mitigated

However, the implementation of the EU Covered Bond Directive – which countries must transpose into national laws by July 2021 – namely, its 180 day net liquidity provision, could result in a payment continuity uplift (PCU) of three notches for cédulas ratings instead of zero currently, said Fitch, offsetting the negative impacts of weakening cover pools.

“The PCU could increase further to six notches should amendments to the cédulas legislation include 12 months’ liquidity protection for principal payments and three months for interest,” they added, “which would mean AAA ratings could be achievable for four of six Spanish programmes, if relied-upon OC is sufficient to support higher rating scenarios.”

As well as the 180 day liquidity rule, the introduction of 12 month maturity extension provisions into the German Pfandbrief Act is expected to increase the PCU for the German product, increasing the buffer against IDR downgrade.

Fitch said in its 2021 outlook that some Danish covered bonds could benefit from a one notch PCU increase if formal provisions to find a refinancing solution without delay in the event of a maturity extension were introduced for certain of the country’s covered bonds, and yesterday (Wednesday) affirmed this, noting that proposed changes to Denmark’s law in this respect will indeed be credit positive and result in a PCU improvement from five to six notches.

“It would affect commercial bank programmes more,” said Fitch, “chiefly by clarifying when a cover pool administrator can be appointed and setting out when it can extend the maturity of a covered bond. This would provide certainty that the covered bond’s maturity could not be extended by the issuer and without seeking refinancing options from the start of the 12-month extension period.”

Covered bonds issued by Danish mortgage credit institutions are unaffected by the change.

Moody’s acknowledged the covered bond directive’s 180 day liquidity buffer as credit positive, as well as its issuer licensing regime, but said other provisions – such as member states having the option to include cover pool assets of lower quality than assets backing most outstanding covered bonds – could potentially prove credit negative.

“Countries may take varying approaches to transposing some parts of the directive,” the rating agency said, “such as the criteria for maturity extensions and liquidity buffer calculations. The new rules will pose particular challenges in Spain, where the legal framework for covered bonds differs from the directive more significantly than other national frameworks, and in Austria, where there are three distinct covered bond laws.”

Most market participants expect benchmark covered bond issuance to remain subdued next year, with issuers again leaning towards central bank funding. The rating agencies highlighted that this could again result in greater asset-liability mismatches, as banks issue shorter dated covered bonds – to benefit from the best terms at central banks – against longer dated assets.

Noting that the average maturity of covered bonds issued around the peak of the crisis in March and April 2020 (which banks mostly retained as repo collateral) was much shorter than for bonds in the same period from 2017-2019, Moody’s said such a trend will increase refinancing risks.

However, while acknowledging such an impact, Fitch also recognised that lower supply in 2021 should support demand for covered bonds.

“This means Fitch is unlikely to change its assumptions in terms of cover pool refinancing risk, which is based on market levels, and which otherwise would also increase breakeven OC ALM loss levels,” it said.