The bank and covered bond rating actions come after Moody’s on 9 February placed the ratings of several members of Sparkassen-Finanzgruppe (S-Finanzgruppe) on review for upgrade, reflecting a potential change in Moody’s assessment of the likelihood of member banks receiving direct or indirect support via the group’s institutional protection scheme (IPS) on the back of updates to IPS statutes early this year that the rating agency said strengthen the support mechanism.

On Friday, NordLB’s senior unsecured rating was lifted from A3 to Aa2, while its long term counterparty risk assessment (CRA) was raised from A3(cr) to Aa2(cr). Its Adjusted BCA (baseline credit assessment) was upped from ba1 to a3, reflecting the S-Finanzgruppe changes, meaning rating uplift from affiliate support improved from two to five notches.

NordLB’s BCA was meanwhile raised from ba3 to ba2, with Moody’s citing “the bank’s resilience in its improved combined solvency profile despite the headwinds from a deteriorated operating environment in Germany”. The BCA also takes into account the bank’s elevated market funding dependence and incorporates a one notch negative corporate behaviour adjustment, the rating agency noted.

NordLB’s mortgage and public sector covered bonds were upgraded from Aa1 to Aaa, with the covered bond anchor now being Aa1 – the bank’s CR assessment plus one notch. The public sector and renewable energy covered bonds of NordLB Luxembourg Covered Bond Bank were upgraded from Aa2 to Aaa, with the Luxembourg entity sharing the same CR assessment and CB anchor as the German issuer.

BayernLB, DekaBank, Helaba, Landesbank Baden-Württemberg and Landesbank Saar were among financial institutions enjoying similar upgrades at the issuer level. The banks’ senior unsecured ratings and CRAs were upgraded from Aa3 to Aa2 and Aa3 (cr) to Aa2 (cr), respectively, on the back of the S-Finanzgruppe changes.

BayernLB’s BCA was upped from baa2 to baa1, and Landesbank Saar’s from ba1 to baa3, while DekaBank’s, Helaba’s and LBBW’s were affirmed at baa2.

The upgrades are a welcome fillip for the sector against the backdrop of commercial real estate-related headlines – just the day before its rating actions, Moody’s published a report noting the high exposure of some German banks to the US CRE market relative to their capital levels, highlighting some Landesbanks alongside specialised lenders.

Please click on the image below to view Moody’s chart

The sale was announced on Thursday, with the transaction expected to close in the second half of this year.

Bawag said the acquisition will expand the group’s footprint in the Dutch retail and SME banking space, and position it for future growth in one of the bank’s core markets.

However, S&P said Aegon Bank’s credit profile will deteriorate after the deal is completed since the bank will face uncertain business prospects, given that it relies primarily on ASR entities – specifically Aegon Hypotheken – to originate mortgages, even if it is due to start its own mortgage proposition this year.

“We think Bawag group is unlikely to provide the same level of support to business generation, given its smaller franchise in the Netherlands,” the rating agency said.

Aegon Bank’s covered bonds – a legacy conditional pass-through (CPT) programme and a newer soft bullet programme latterly used for benchmark issuance – are rated by only S&P. The AAA ratings are not considered by analysts to be at risk.

ING head of financials strategy Maureen Schuller, for example, noted that the soft bullet still has two unused notches of collateral uplift, while the rating of the CPT programme is delinked from issuer rating pressure under S&P’s methodology for such covered bonds.

Commerzbank head of financials and covered bond research Ted Packmohr meanwhile said the acquisition raises questions over the future issuance activity from Aegon and Bawag. He noted that one-third (€3.8bn) of the cover assets of Bawag mortgage Pfandbriefe already come from its Dutch business.

“Hence, it cannot be ruled out that this channel will also be used for Aegon’s new lending business in the future in order to realise larger economies of scale,” he said, highlighting that, after being acquired by Bawag, Südwestbank in Germany became a German branch of the Austrian bank and ceased issuing Pfandbriefe.

However, he noted that various considerations, such as Aegon’s size, could merit it maintaining an independent capital markets funding hub, while the tighter levels of Aegon covered bonds versus Bawag’s could even see the Dutch entity issuing more by incorporating Dutch assets that would hitherto have been funded via Austrian covered bonds.

My Money Group – managed by Cerberus Capital Management – announced that its long-planned acquisition of the retail banking activities of HSBC Continental Europe (HBCE), including HSBC SFH, was finalised on Monday.

HSBC SFH has been renamed CCF SFH, with the acquiror renaming itself CCF Group, having also entered into a long term agreement with HBCE to rent and use the historic Crédit Commercial de France brand. CCF SFH will be a subsidiary of the group’s retail banking Banque des Caraibes entity, which is being renamed CCF.

The group already has its own covered bond issuer, MMB SCF, named after parent My Money Bank, a speciality finance subsidiary.

Moody’s on Tuesday withdrew its Aaa rating of the transferred covered bonds, citing business reasons, while S&P affirmed its AAA ratings but revised the outlook from stable to negative, reflecting its negative on CCF’s BBB- rating and that there are no unused notches of uplift to support the covered bond rating in case of a negative rating action on the parent bank.

Royal Bank of Canada meanwhile on 21 December received ministerial approval to proceed with its acquisition of HSBC Canada, with the deal expected to close in the coming months.

Also last month, Morningstar DBRS (rebranded from DBRS Morningstar as of Tuesday) confirmed its AAA rating of Laurentian Bank covered bonds.

It had on 30 November placed them on review with negative implications after having done likewise with the bank’s A (low) long term issuer rating. However, a mechanistic downgrade of the covered bonds would only have followed an issuer downgrade of two or more notches, and a downgrade of only one notch, to BBB (high) ensued.

The rating agency had said the AAA covered bond rating could withstand a one notch downgrade if covered bond programme overcollateralisation (OC) was increased to a level where the cover pool credit assessment (CPCA) is triple-A, and when confirming the rating on 15 December, Morningstar DBRS cited an OC level of 22.0% (based on an asset percentage (AP) of 82.0%) to which it gives credit, up from a 15.0% level (based on an 87.0% AP as at 31 October) cited on 30 November.

“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.

The rating agency on 3 November placed the A (low) long term issuer rating of Laurentian Bank of Canada (LBC) under review with negative implications.

“The Under Review with Negative Implications designation reflects DBRS Morningstar’s view that these adverse series of events in aggregate have weakened LBC’s franchise strength and future growth prospects, pressuring the credit ratings. LBC’s personal banking business, which has already had weaker earnings than its peers, has been under pressure with customer attrition, shrinking loans, and stagnant deposits in recent years.”

The bank had concluded a strategic review of options in mid-September that decided against a sale.

DBRS Morningstar said yesterday that the AAA rating of Laurentian’s two outstanding covered bonds – both Canadian dollar-denominated, totalling C$2bn (€1.35bn) – have been placed under review with negative implications.

According to the rating agency, the covered bonds will be downgraded if the A (low) long term senior debt rating of Laurentian (its covered bond attachment point, CBAP) is cut by two notches or more, while the AAA rating can withstand a downgrade of one notch if covered bond programme overcollateralisation is increased to a level where the cover pool credit assessment (CPCA) is triple-A.

S&P upgraded the sovereign from A to A+, on stable outlook, on 10 November, citing strong growth and fiscal consolidation.

Under S&P’s methodology, the three banks’ covered bond programmes enjoy two notches of uplift from their long term issuer credit ratings to reach reference rating levels (RRLs) of a-, and are eligible for two further notches of uplift above this because of the rating agency’s jurisdictional assessment of Icelandic mortgage covered bonds as being strong.

The jurisdictional uplift was, however, previously capped at that of the sovereign, but the two available notches now enable the programmes to achieve jurisdiction-supported rating levels (JRLs) of a+.

“We have not assigned collateral-based uplift for these programmes, as we assess that overcollateralisation is currently insufficient to cover the various credit and cash flow risks that we consider in our analysis,” added S&P. “In our continuous surveillance of the programmes, we will monitor any changes in our assessment.”

The consequent A+ ratings of the programmes are now on stable outlook, having previously been on positive outlook.

The outlooks on the BBB long term issuer credit ratings of Íslandsbanki and Landsbankinn were meanwhile revised from stable to positive on 17 November, and Arion’s from negative to stable.

S&P is the only rating agency to rate any of the three Icelandic covered bond programmes.

The sovereign upgrade to A3, on stable outlook, reflects the sustained positive credit effects over the medium term of a series of economic and fiscal reforms, private sector deleveraging and ongoing strengthening of the banking sector, according to Moody’s.

The rating action on the government was accompanied by a lifting of Portugal’s country ceilings from Aa2 to Aaa, reflecting a six-notch gap for which Eurozone jurisdictions are typically eligible under the rating agency’s methodology.

On the back of the sovereign upgrade, Moody’s upgraded seven Portuguese banks, among them covered bond issuers Banco BPI (upped from A3 to A2), Banco Comercial Português (BCP/Millennium bcp) (Baa2 to A3), Banco Santander Totta (A3 to A2), Caixa Geral de Depósitos (CGD) (Baa1 to A3), Caixa Economica Montepio Geral (Banco Montepio) (Ba2 to Baa3), and Novo Banco (Ba3 to Ba1). Their counterparty risk (CR) assessments also improved.

“The increase in the starting points for the covered bond ratings (CB Anchor) enabled all Portuguese issuers to raise their mortgage covered bonds to the level of Aaa by maintaining the necessary overcollateralisation,” noted DZ analysts.

“The public sector covered bonds of Banco BPI were also upgraded, but only by one notch from Aa3 to Aa2. In our opinion, Moody’s rating methodology would have allowed a higher upgrade. We suspect that the issuer was not prepared to commit to the necessary overcollateralisation.

In upgrading the Portuguese mortgage programmes, the rating agency also noted that it had also lowered its refinancing margins for all Portuguese covered bonds, citing, in addition to macro improvements, a significant reduction in their spreads over the last years, and successful implementation of the EU covered bond directive, reinforcing their systemic importance.

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

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.

Moody’s upgraded Portugal from Baa3 to Baa2 on Friday, citing an improvement to the country’s longer term growth prospects thanks to NextGen EU funds and structural reforms, as well as an expectation that its debt burden will decline on the back of such growth and more effective fiscal policymaking. Concurrently, Portugal’s country ceilings were raised from Aa3 to Aa2.

The rating agency yesterday (Tuesday) upgraded from Aa3 to Aa2 the mortgage covered bonds (obrigações hipotecárias, OH) of Banco BPI, Banco Comercial Português (Millennium bcp), Banco Santander Totta and Caixa Geral de Depósitos (CGD), and the mortgage covered bonds of Caixa Económica Montepio Geral from A1 to Aa3.

The Counterparty Risk (CR) assessments of Banco BPI and CGD were yesterday lifted one notch, from Baa2(cr) to Baa1(cr), amid a variety of issuer upgrades across Portuguese banks.

Moody’s also lowered its refinancing margins for all Portuguese covered bonds, and raised the timely payment indicator (TPI) of CGD’s programme from “high” to “very-high”. It said that as well as the improvement in the Portuguese economy, the adjustments reflected “the significant reduction of covered bond market spreads in Portugal over the last years, and the near term implementation of the EU directive on covered bonds, which will reinforce strengths of the Portuguese covered bond law and the systemic importance of Portuguese covered bonds”.

Banco BPI public sector covered bonds, rated A1, were put on review for upgrade, reflecting a potential upgrade if the issuer maintains overcollateralisation (OC) consistent with a higher rating, Moody’s said. During the review, it will assess the willingness and capacity of the issuer to maintain sufficient OC on a sustained basis. The highest rating now achievable is Aa2, the country ceiling.