Rating agencies expect covered bond credit quality to remain strong in 2022, with issuers and sovereigns enjoying stable outlooks, and covered bond protections mitigating against risks to collateral, although the recent emergence of Omicron has heightened the key downside risk.

S&P noted that it has not downgraded any covered bond programmes since the beginning of the Covid-19 pandemic and its outlook for covered bond remains stable. The rating agency highlighted that the credit enhancement available to most programmes it rates is on average more than eight times required to maintain current ratings, and they have on average 2.2 unused notches of buffer against issuer downgrades.

The picture is similar at Moody’s, where sovereign outlooks are stable for all but one country in which it rates covered bonds (Turkey), and other factors offer reassurance.

“We expect covered bond credit quality will remain strong overall in 2022, because our rating outlooks are stable or positive for around 85% of covered bond issuers, and asset performance will remain strong as pandemic effects lessen,” said Edward Manchester, senior vice president at Moody’s.

Almost all covered bonds rated by Fitch were on stable outlook at the end of October, the rating agency highlighted, supported by an average potential uplift of 8.6 notches above Issuer Default Ratings and ample overcollateralisation (OC). Only four programmes out of the 101 that it rates had a negative outlook or Rating Watch Negative.

Fitch: Global covered bonds – rating changes

Source: Fitch Ratings

“We expect cover pools to remain of high credit quality in 2022 given the prime nature of cover assets,” said Fitch analysts. “None of the Fitch-rated covered bond programmes reported a growth in delinquencies when payment holiday schemes were unwound in most countries.”

However, they believe a marginal increase in arrears could arise once government support measures are lifted, as weaker borrowers could see their situation worsen.

Fitch published its outlook on 25 November, just before Omicron hit the headlines, while Moody’s came out on 2 December, in the wake of the emergence of the new Covid-19 variant, and it flagged a downside scenario in which vaccine-resistant variants emerge that prolong the crisis and require new containment measures.

S&P, which delivered its outlook last Thursday (9 December), cited Omicron among key risks to the outlook for banks, highlighting possible interruption to the ongoing recovery, most likely from higher Covid-19 infections, concerns arising from the new virus variant, or a decline in vaccine efficacy.

CRE segments flagged, but resi resists pressures

House prices have risen to historically high levels relative to incomes amid the pandemic, and Moody’s warned that affordability risk for new mortgages has increased.

However, it highlighted the strong protective features of covered bonds that will mitigate against potential 2022 property price falls or other adverse market developments, noting that overcollateralisation (OC) levels for residential mortgage covered bonds mostly exceed 50% and that recent property price gains have increased equity buffers.

Moody’s: Covered bonds have high OC levels and low indexed LTV ratios
OC levels and LTV ratios for residential mortgage covered bond programmes in select markets

Note: Exhibit based on available data reported between September and November 2021. Where LTVs are reported as ranges, midpoints have been used in weighted average calculations; Source: Moody’s Investors Service

Certain segments of commercial real estate (CRE) assets are more at risk, according to S&P, even if the CRE landscape is in general stabilising. It said lodging will take longer to recover given travel restrictions and looming uncertainty over the return of business and group travel, while societal changes depress demand for retail and shift office demand to higher quality space. This is expected to drive industrial and residential assets to outperform commercial real estate assets.

“While we believe that commercial real estate asset performance may deteriorate in certain sectors, we do not anticipate this significantly impairing the credit quality of the covered bonds that we rate,” added S&P. “This is due to the availability of credit enhancement to absorb losses and the limited exposure to the sectors that we consider to be most at risk.”

S&P: Rated programmes with highest exposure to CRE assets

Note: Data labels show the average ratio of available credit enhancement to credit enhancement required for current ratings; Source: S&P Global Ratings

Directive impact positive, if on time

The impact of the EU covered bond directive is set to be factored into ratings next year, given an implementation deadline of July 2022. Only a handful of member states had transposed it into national law by the required July 2021 date, with the pandemic delaying the process in most countries, and the European Commission has flagged potential infringement procedures against the laggards.

S&P said it expects member states with large covered bond markets to be able to meet the July 2022 target date, but noted that regulatory advantages could otherwise be lost. Moody’s also warned that eligibility for preferential treatment would be uncertain if the July deadline is missed, and that such uncertainty would limit issuers’ ability to place new covered bonds until implementation occurs.

The rating agencies generally expect directive implementation to be positive or, at worst, neutral for EU and EEA jurisdictions.

“The directive will be positive for European covered bonds because it sets minimum credit standards that exceed current requirements in many countries,” said Moody’s. “Moreover, the harmonisation of credit standards will promote the development of an integrated single market for covered bonds in the EU, which will enhance systemic support for the sector.”

Any rating actions are set to depend on the extent and nature of changes to national legislation.

“The implementation of the EU covered bond directive could drive upgrades in mid-2022 in Portugal and Spain,” said Robert Del Ragno, director, Fitch Ratings, for example.

Spain is subject to the biggest upheaval from implementation, and Fitch said the introduction of a mandatory 180 day net liquidity provision and the possibility of issuing bonds with maturity extensions in Spain could lead to multi-notch upgrades, subject to sufficient OC protection to support higher rating stresses.