The bail-in of senior debt under a new EU bank recovery and resolution directive (BRRD) could widen the difference between covered bonds and senior unsecured debt ratings, Fitch said today (Tuesday), but the rating agency is not planning any near term covered bond criteria changes.

Fitch, Canary Wharf

“Unlike covered bonds, it is proposed that banks’ senior unsecured debt will technically be eligible for bail-in if conditions for resolution are met and early intervention measures or the write-down of junior debt has proven insufficient to restore viability,” it said. “This effect could in theory widen the difference between the covered bonds rating and the senior unsecured debt rating of a given European institution.”

However, Fitch noted that this would not, strictly speaking, represent a change to its covered bond methodology because the starting point for its analysis of covered bonds is not an institution’s senior unsecured debt rating but its Issuer Default Rating (IDR). While the senior unsecured rating incorporates expectations of recoveries given default, it said, IDRs indicate an entity’s vulnerability to default and are independent of recoveries achieved on a specific assets class.

“Fitch continues to believe that the IDR is an appropriate reference for covered bond ratings given the first recourse of bondholders to a financial institution,” it said.

The rating agency noted that under the BRRD default could occur in several ways that might not lead to the cover pool taking over an issuer’s obligation towards covered bond investors, with a liquidation scenario arguably becoming less likely. However, it said that the nature of a bank default is not foreseeable in advance and that the IDR therefore remains the most reasonable proxy at this stage.

Fitch nevertheless said that it could depart from this convention once there is greater visibility of the type of default an institution is likely to suffer. It noted that in Cyprus IDRs are no longer the starting point for covered bond risk assessment.

More generally, Fitch said that the draft nature of the BRRD and discretion that is likely to be afforded to national resolution authorities explain why it is not planning near term changes to its covered bond rating methodology.

“Although positive for covered bondholders as these securities are currently explicitly excluded in the proposals from the scope of the directive’s bail-in tool, other aspects of the protection currently enjoyed by investors are left unclear, such as the treatment of voluntary overcollateralisation above the mandatory minimum,” it added.