Covered bonds’ credit quality is expected to withstand a deterioration in asset quality in 2024, given an anticipated soft-landing combined with programmes’ protections, but Fitch, Moody’s and S&P all flagged downside risks from worse than expected macro and idiosyncratic developments.

“Despite weakening asset performance amid higher-for-longer interest rates, the credit quality of covered bonds will be stable in 2024, reflecting the mostly stable credit strength of issuers and the sovereign debt of countries they operate in,” summarised Moody’s.

All but one of 101 Fitch-rated covered bond programmes was on stable outlook as of early December 2023, supported by an average potential uplift of 8.5 notches above bank issuer default ratings (IDRs) and 3.6 notches of IDR downgrade buffer.

Fitch: Global covered bonds – rating changes

Source: Fitch Ratings

The interest rate outlook looms large over any risk factors the covered bond sector could face in 2024.

While S&P Global expects a soft landing for the European economy, for example, with inflation past its peak and the European Central Bank gradually cutting rates in the second part of 2024, it warns that the return to positive real interest rates will take a toll on economic growth. The rating agency highlighted the sustained correction in European housing markets triggered by rising interest rates, as well as the squeeze on commercial real estate (CRE) valuations.

CRE is a focus for all three rating agencies, although they all see mitigants for covered bonds.

“Higher-for-longer interest rates are squeezing CRE valuations, pushing capitalisation rates up and weighing on debt service coverage ratios,” said S&P. “Access to funding has narrowed, which could affect liquidity and borrowers’ refinancing plans.”

“Banks’ well-diversified loan portfolios and conservative underwriting should mitigate losses,” it added, “although office exposures could suffer from longer-term changes in work arrangements. Vacancy rates in retail continue to rise as online sales penetration keeps increasing.”

S&P: CRE loans represent only around 11% of total lending for large EU banks, but more in some covered bonds

Note: Average CRE loan exposures for system-wide bank balance sheets and covered bond cover pools. Data as of June 2023. Source: European Banking Authority, S&P

Fitch expects a deterioration in EMEA office and retail real estate sectors in 2024, but also sees mitigants for covered bonds with exposure to CRE.

“German Pfandbriefe have strong legislative protection,” it added, “with conservative valuation methodologies for CRE properties.”

Moody’s also highlighted that refinancing risk for CRE loans in cover pools will be relatively low in 2024 because the assets are reasonably well seasoned. Around half of CRE loans in German cover pools were originated in 2018 or earlier, according to Moody’s, which said they therefore benefit from significant property value appreciation.

“Moreover, cover pool loans that were originated at the peak of the property cycle in 2021 and 2022 generally do not mature before 2026,” added the rating agency.

ESG considerations are also seen as increasingly influencing real estate collateral. Moody’s said that CRE refinancing prospects could be affected as properties with low energy efficiency may fail to qualify for bank funding by falling short of lenders’ criteria and the fear that they may become stranded assets.

And Fitch warned that policy measures to address climate transition risk could affect the underlying drivers of cover pool property values, as energy efficiency considerations become an increasing focus for buyers and lenders.

“The impact of these policies on housing market fundamentals will depend on available incentives for both borrowers and lenders to transition to ‘greener’ homes,” it added.

Residential pressures cited, but protections ‘ample’

On the residential side, S&P warns that the “mortgage rate shock” will take time to play out, with higher rates taking time to feed fully through to household finances thanks to a pivot towards fixed rate products from variable rates in recent years. It expects a sustained correction in nominal house prices in most European countries – from pandemic-induced highs – as Eurozone growth softens considerably.

“We generally anticipate more pressure in countries with a high share of variable-rate mortgages and where the interest rate rise is highest,” the rating agency said.

It cited household savings buffers, prudent underwriting standards and a still tight labour market a supportive of residential mortgage performance. Moody’s also sees unemployment remaining low and being supportive of house prices and cover pool performance, with an ongoing recovery in real rage growth as inflation falls potentially contributing to buttressing collateral quality.

Moody’s also cited government regulatory and fiscal initiatives undertaken in a variety of countries as cushioning the impact of macroeconomic developments.

“However, given the measures already taken and the effect of persistently high interest rates on government finances, the potential for expanded state support of mortgage borrowers may be constrained in 2024,” it warned.

Fitch meanwhile flagged the potential for greater covered bond issuance volumes at higher coupons to continue to squeeze programme excess spread, especially in jurisdictions with long-dated, unhedged, fixed rate cover assets, such as Belgium, France, Germany and the Netherlands.

“Recent subdued origination volumes could exacerbate interest-rate mismatches if issuers top up pools with fixed rate loans originated at previously lower rates (UK, Italy), but this lag in repricing is expected to be short lived,” it added. “Recent issuances at higher rates also have shorter tenors, mitigating any longer term impact on excess spread, but this increases programme maturity mismatches.”

But Fitch noted that covered bonds it rates benefit from ample overcollateralisation (OC): nearly 75% have available OC that is more than twice the level supporting their ratings.

And however 2024 plays out, residential covered bonds enjoy strong structural protections, according to Moody’s: in most countries average OC exceeds 50% and, despite the recent colling in house prices, loan-to-value (LTV) ratios typically remain under 50%. Overall, in many countries house prices would have to decline by more than 65% before the total value of properties securing cover pool loans only just equals the amount of covered bonds, the rating agency calculated.

“Moreover, should the credit quality of cover pools substantially deteriorate, we expect issuers will choose to add further loan collateral,” said Moody’s. “The amount of eligible residential mortgage assets outside cover pools varies across countries. However, it is generally substantial.”

Banks resilient, but subject to macro, model downsides

Issuer credit quality is a key contributor to the stable outlook for the covered bond sector, with 95% of Moody’s published outlooks for issuers globally being stable or positive, for example. And Moody’s could downgrade issuer ratings by 3.3 notches on average without triggering lower covered bond ratings under its timely payment indicator (TPI) framework – although the rating agency noted a material degree of variation across countries.

Moody’s: Most covered bond ratings can withstand multi-notch issuer downgrades – Average TPI leeways (notches) for covered bonds with publicly-rated issuers

Note: As of latest published performance overview reports. Average calculated at programme level; Source: Moody’s Investors Service

“In the face of weakening asset performance in 2024, the credit strength of issuers will underpin stable credit quality for covered bonds because issuers are the primary source of bond payments,” said Moody’s. “However, our outlook for global banks has turned negative, reflecting the deteriorating operating environment under tight monetary policies.”

S&P expects European banks to be resilient in the coming 12 months, with solid capitalisation and liquidity contributing to this in the face of potential shocks. It foresees earnings remaining comfortable, allowing banks to easily absorb higher credit costs.

However, it flagged the risks to asset quality and downside risks including a painful recession, market volatility and financial instability, and banks’ failure to delivery commercially and operationally resilient business models.

“Failure to tackle inefficiencies, properly digitalise the business, and sustain resilience to cyber attacks could challenge the long term viability of some institutions,” warned S&P.

Fitch also highlighted idiosyncratic bank downgrades as something to watch out for, given their potential to flow through to covered bond ratings for programmes with limited IDR downgrade buffer.

A deeper and prolonged material macroeconomic deterioration is also perceived as a downside risk by Fitch, which warned that unemployment increasing beyond its expectations would affect arrears, especially if interest rates peak higher and later than forecast.

“The latter would also weigh on house prices,” it added. “Geopolitical risks may derail economic recovery: prolonged tensions between Russia and Ukraine and wider conflicts in the Middle East could undermine our forecast inflation decrease amid pressure on energy and food prices.”

Sovereigns supportive, with Directive still in play

Sovereign credit quality is broadly expected to have a stable to positive impact on covered bond credit quality. Moody’s outlooks for countries in which it rates covered bonds are all stable with the exception of Slovakia, whose rating is on negative outlook.

With 97% of the covered bonds it rates have stable or positive outlooks, S&P noted that only three programmes have a negative outlook – in line with the corresponding sovereign. Meanwhile, upgrades to Iceland and Greece were among the drivers of S&P covered bond upgrades in 2023, which numbered five.

Rated covered bond programmes would, on average, maintain the current ratings if their respective sovereigns were downgraded by up to 2.6 notches, all else being equal, at S&P.

“We would expect mortgage programs in Greece, Italy, and Spain, as well as programs backed by public sector assets in Belgium, France, and the UK, to be most sensitive to changes in the respective sovereign ratings,” it added.

Fitch highlighted positive momentum from southern European sovereigns. A higher country ceiling for Portugal means that covered bonds there could be rated up to AAA by Fitch for the first time since 2010. And a recent upgrade of Greece to BBB- by the rating agency could also affect covered bonds, with an ensuing recalibration of asset assumptions potentially lowering credit loss levels, reducing the breakeven OC for ratings.

However, Fitch noted that a Hungarian covered bond programme is on negative outlook as its reference IDR reflects the sovereign IDR’s outlook, which is negative. Erste Jelzalogbank mortgage covered bonds are currently rated A, on negative outlook.

Portuguese covered bonds are also flagged by Fitch as potentially benefiting from the ongoing impact of EU Covered Bond Directive-inspired developments. The migration of two Portuguese programmes to obrigações cobertas could see their payment continuity uplift (PCU) under Fitch’s methodology rise to four to six notches from zero, depending on the calculation of their 180 day liquidity buffers and subject to OC sufficiency, counterparty risks and the liquid asset types included in cover pools.