Macroeconomic pressures may hit residential and commercial mortgage collateral quality in 2023, but rating agencies do not expect the headwinds to be sufficiently severe so as to affect covered bond ratings, even if idiosyncratic and event risks could spring surprises.

S&P Global prefaced its outlook for covered bonds by highlighting the choppy macroeconomic waters through which the instrument will have to navigate in 2023, forecasting that European economic growth will come to a halt early next year, before recovering from mid-year. Sticky inflation, stunted hiring and higher interest rates were among the negatives it cited.

The cost of mortgage finance has tripled in some countries since the beginning of 2022, according to the rating agency, making it increasingly difficult for first-time buyers to enter the market when combined with increases in house prices.

Moody’s: House prices are weakening in response to mortgage rate increases
Quarterly house price changes in 2022 and one-year change in mortgage rates

Source: Moody’s – see end of article for full notes and sources

However, S&P and its fellow rating agencies cite labour market resilience, government support measures, and an expected easing of inflation and interest rate hikes as meaning that house prices will not fall sharply and the impact on collateral performance will be mitigated. Despite noting that house prices in many countries are at historic highs following pandemic-era gains, exacerbating risks, Moody’s does not envision disorderly downturns similar to those experienced during the global financial crisis; rather, it expects price declines in the low to mid-single digits range in many countries where it rates covered bonds.

Alongside methodological cushions against covered bond downgrades, overcollateralisation levels are also unanimously seen as offering comfort. Fitch said it is confident in covered bonds’ ability to withstand a darkening economic outlook thanks partly to this factor, noting that the levels of OC it relies on in its analyses were at least twice the breakeven OC for the assigned ratings for more than 60% of programmes it rates as of end-November.

“Cover pools’ positive selection and overcollateralisation cushions will mitigate the deterioration in asset performance arising from pressure on households’ capacity to service debt resulting from high inflation, rising interest rates and high energy costs,” the rating agency said.

It cited Portugal, Greece and Spain as being more exposed to the impact of rising interest on reducing borrowers’ capacity to pay due to the high share of variable rate loans in those countries, but noted that programmes from jurisdictions with a high share of fixed interest loans will see a reduction in available excess spread as liabilities reprice more rapidly than assets. Moody’s also flagged these issues, highlighting Australia, the Nordics and the UK in the floating (or short-term fixed) rate camp, and Belgium and France in the fixed rate camp.

Fitch nevertheless flagged the potential for policy changes to affect cover pool quality.

“If regulators intervene in the payment schedule of underlying mortgage loans, as see in the law on payment on holidays in Poland, this could affect cover pool performance and the cashflows available for covered bonds in the event of an issuer default,” it said. “In addition, some property values would be negatively affected if policymakers penalise non-energy efficient housing.”

While the rating agencies focussed more on residential collateral, commercial real estate was flagged as facing risks in the coming year.

“Rising interest rates will lead to a decline in CRE values that will likely be more pronounced than the fall in residential property prices,” said Moody’s, noting a rise in default risk. “For prime CRE markets in Western Europe, property yields are 150bp-200bp below long term averages, which suggests CRE properties are overvalued.

“Meanwhile, rising central bank lending rates and government bond yields have sharply compressed the CRE risk premium over the past year, heightening the risk of lower CRE values.”

The rating agency noted mitigants such as fixed interest rates and the ability to increase rent in line with inflation if tenants and lease lengths allow, but conversely highlighted risks arising from structural shifts like online shopping and working from home.

S&P cited similar trends, noting that commercial real estate was under renewed pressure after having come through the pandemic. However, the rating agency does not expect an anticipated deterioration in asset performance to significantly impair the credit quality of the respective covered bonds it rates, due to the availability of credit enhancement to absorb credit losses, and limited exposure to sectors considered to be more at risk.

Issuers strong but face risks

The regulated financial institutions that tend to issue covered bonds have built up strong capital and liquidity buffers in recent years, notes Fitch.

“This should help absorb the impact of a recession in 2023,” it said.

Only 4% of issuers of Fitch-rated covered bonds are not on stable or positive outlook or Rating Watch Positive.

Fitch: Banks vs. Covered Bonds Rating Outlook/Watch

RWN – Rating Watch Negative; Evolving – Rating Watch Evolving or Outlook Evolving; RWP – Rating Watch Positive; Source: Fitch Ratings

S&P has a stable ratings bias for banks, but warned that the possibility of more negative outlooks regarding cannot be disregarded given sizeable downside risks to its macro projections, which could put pressure on earnings and loan performance.

“Given extreme volatility, banks could also face unexpected event risks,” it added.

The status of sovereign ratings is similarly supportive of the asset class, with Moody’s, for instance, noting that relevant countries have predominantly stable or positive outlooks, and only a small number negative, mainly European countries most severely affected by energy supply risks.

S&P-rated covered bonds could on average withstand sovereign downgrades of up to 2.5 notches, all else being equal, with Greek, Italian and Spanish mortgage programmes being the most vulnerable, as well as programmes backed by public sector assets in Belgium, France and the UK.

Regarding public sector collateral in general, Moody’s said it expects debt burdens to rise in several countries, but that European sovereigns’ robust tax bases will contain their debt burdens as a share of revenue.

“Tighter monetary policy and financial conditions will weaken debt affordability,” it added.

Unfinished harmonisation business

The covered bond market passed the EU Covered Bond Directive milestone in July, but S&P noted that the journey continues, with implementation work still to be done in various jurisdictions.

“We consider that the transposition of the directive is positive for covered bonds, and although changes to the law have meant some delays to issuance in some countries, we expect issuance to normalise within the next few months,” said S&P.

“Despite best efforts, differences remain between jurisdictions,” it added. “We expect that regulators and issuers will eventually converge, and we do not expect any negative rating impact.”

Moody’s also noted unfinished harmonisation business, but offered a positive spin.

“We expect that national laws and market practices that exceed the requirements of the directive will remain a key driver of credit standards,” it said. “Market practices typically consist of protective contractual features, but also include operational measures that mitigate risks, such the exclusion from cover pools of mortgage loans from outside the European Economic Area (EEA).”

The phasing-in of the EU directive implementation could lead to further notches of uplift for Portuguese and Swedish covered bonds at Fitch, although the rating agency flagged that this could be delayed until 2024. In Portugal, the introduction of “obrigações cobertas”, including a liquidity buffer covering 180 days, could lead to upgrades up to Fitch’s AA+ country ceiling for three soft bullet programmes if issuers convert to the new framework and OC is sufficient to support higher ratings, with the programmes’ payment continuity uplift (PCU) potentially increasing from zero to six notches.

Notes for Moody’s chart: One-year change in mortgage rates from September 2021 to September 2022. Euro area: composite borrowing rates; UK: 5 year fixed (75% LTV); Australia: 3+ year fixed; Canada: 5+ year fixed, New Zealand: 5 year fixed, Sweden: 3-5 year fixed. 2022-Q3 house price data unavailable for Italy and France. Australia house prices based on five capital city aggregate. Source: Moody’s Analytics, ECB, Bank of England, Reserve Bank of Australia, Riksbank, Bank of Canada, Reserve Bank of New Zealand, Valuegard, CoreLogic and QV