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

“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.

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.

The rating agency on Friday upgraded Cyprus’s rating from Ba2 to Ba1, citing a reduction in its exposure to event risks because of a decrease in banking sector risks, as well as its economic resilience to the pandemic shock and robust medium term GDP growth prospects, supported by sizeable European funds.

Last Wednesday (21 July), Moody’s also upgraded Bank of Cyprus’s ratings, including its counterparty risk (CR) assessment from B1(cr) to Ba3(cr). It said the rating action captures the bank’s strengthened standalone credit profile and improved solvency, providing an increased buffer to the bank to navigate still-challenging conditions following the pandemic.

When upgrading the sovereign rating, Moody’s lifted Cyprus’ local and foreign currency country ceilings from A2 to A1. But it said that at present, covered bonds cannot reach the country ceiling because of: high correlation of risks within the banking system, resulting from the small number of players and their large size relative to the size of the economy; a still-high number of nonperforming loans in the banking sector; and challenging economic conditions posed by the coronavirus pandemic.

“In a hypothetical scenario where the sovereign were to default and a covered bond anchor event were to occur for the Bank of Cyprus, a disruption of servicing may result in a weakening of collections activities, leading to increased delinquencies, lower recoveries, and ultimately higher losses on the cover pool,” said Moody’s.

The effective servicing of the cover pool and likely recoveries from the assets are commensurate with a Baa1 rating, it noted.

To reflect a reduction of risks in the housing market in the past few years, Moody’s has lowered its collateral risk calculation for Bank of Cyprus covered bonds. However, it noted this also reflects downside risks related to the potential formation of new nonperforming loans, due to the fluidity of the pandemic and Cyprus’s exposure to the tourism sector and a high number of restructured loans in the country.

The rating agency noted that it does not apply its timely payment indicator (TPI) framework to Bank of Cyprus’ covered bonds programme, which has a conditional pass-through structure.

Rating agencies generally agree that weakening cover pool asset quality due to the ongoing impact of Covid-19 in 2021 – including increased residential mortgage arrears and defaults as payment holidays end, and reduced commercial real estate (CRE) values – will not materially hurt the credit quality of most covered bonds due to sufficient mitigating factors, primarily high levels of available overcollateralisation (OC).

Moody’s said that as the ongoing economic fallout from the coronavirus impacts asset values and borrowers’ ability to service debt, cover pool collateral performance will worsen, but given most covered bonds benefit from high OC (mostly exceeding 40%) and cover pool mortgages generally have low LTV ratios (of around 50%), the credit quality of covered bonds will not be impacted.

“Additionally, issuers have historically provided voluntary support where necessary to prevent a deterioration in covered bond credit quality,” the rating agency added, “typically by substituting good loans for bad loans in cover pools.”

Moody’s: Weighted average OC and indexed LTV ratios for residential mortgage covered bonds in select markets

Source: Moody’s; Note: Based on available data reported between September and November 2020. Where LTVs are reported as ranges, midpoints are used in weighted average calculations. Weighted average OC for Germany excludes extreme outlier.

In its 2021 outlook, Fitch echoes this expectation, stating that OC is currently a constraint on its ratings for just four programmes, in Greece and Denmark, with the majority of its covered bond ratings protected from asset quality deterioration.

“Covered bond programmes all have a lot of OC cushion and most mortgage programmes have contractual protections such as asset coverage tests,” said Natasha Guérer, director, covered bond ratings, Fitch.

“The negative outlook on some covered bonds could remain in place for a while,” she added, “as government support to economies and borrowers is gradually withdrawn, but they won’t necessarily translate into downgrades unless the downturn is deeper or more prolonged.”

While S&P also foresees limited negative impact on prime residential mortgage loans, it finds key risks in jurisdictions where it anticipates higher unemployment, such as the UK and Spain, and in cover pools with significant exposure to borrowers who are self-employed or on temporary contracts.

The rating agency expects the performance of commercial real estate (CRE) assets to be the most severely affected by secular trends, such as the growth of home working and e-commerce. However, these generally constitute a relatively small part of the cover pools backing programmes it rates so it does not anticipate this impairing the credit quality of covered bonds to a significant extent.

Gordon Kerr, head of structured finance research, Europe, DBRS, said that while Q4 2020 growth is likely to be subdued in many countries due to the ongoing impact of the second wave of coronavirus, the recent progress made in implementing an effective vaccine means there is a lower risk of a prolonged slump in global growth into 2021.

“The expectation from our scenarios is that European unemployment rates are going to increase in 2021 before they start to recover in 2022,” he said, “but this depends on how long government measures continue to support both companies and individuals as we move into next year.”

Sovereigns less of a source of concern this time

The credit quality of issuers and sovereigns will weaken in the new economic environment caused by the coronavirus outbreak, according to the rating agencies, but in most markets where covered bonds are rated, issuers and sovereigns entered the crisis in relatively strong positions and therefore have a broadly stable outlook for 2021.

Moody’s said that while its global outlook for sovereign creditworthiness is negative, its rating outlooks for most countries in which it rates covered bonds are largely stable, with only two European mortgage covered bond markets – Romania and Turkey – on negative sovereign outlooks. Given sovereign downgrades were the primary driver for covered bond rating actions between 2008-2012, it expects covered bond credit quality to remain strong overall in 2021.

S&P similarly expects most sovereign ratings to remain stable, having placed only Spain and Slovakia on negative outlooks. Moreover, with some exceptions, it said covered bond ratings in most jurisdictions would not change in the case of a one-notch downgrade of the sovereign rating. The rating agency goes on to flag Greek, Irish, Italian and Spanish covered bonds as those most sensitive to changes in their respective sovereign ratings, as well as those backed by public sector assets in Belgium, France, and the UK.

The ratings of Cypriot, most Italian and one Greek covered bond programme are most at risk from a weakening in sovereign credit profiles via an increase in sovereign indebtedness, according to Fitch. However, it deems this unlikely given all three jurisdictions’ issuer default ratings (IDRs) are on stable outlook, with only one covered bond rating from Panama on negative outlook.

“Country ceilings are not a direct threat to these ratings, as evidenced by the stable outlooks on Cyprus, Greece and Italy’s IDRs,” the rating agency said.

Regarding Brexit, Fitch predicts the impact on UK covered bond ratings to be limited, even assuming UK-EU trade moves to WTO terms and significantly curtails the pace of UK recovery in 2021.

“Excluding one programme rated A/RWN, UK covered bonds’ AAA ratings can sustain between three to five notches of IDR downgrades, and substantial OC cushion provides protection against performance deterioration,” it said.

DBRS’s Kerr said the risks posed by Brexit coupled with the effects of the pandemic has led to increased uncertainty over the economic impact that will be felt in both the UK and EU.

“Normally, we would have seen a prospect of a dip in both economies as they’re both fighting the pandemic,” he said. “In terms of recovery out of it, Brexit creates even more uncertainty in how this will impact them and discern which impacts are from Brexit and from Covid.”

The impact of a hard Brexit could be relatively severe, added Kerr, although he said that given there has been a long lead time, many businesses will have put preparations for such a scenario in place already.

“We do not know whether we will have a deal come the end of the month, so I think it’s a case of people crossing their fingers and hopefully being prepared for the worst case scenario either way,” he said.

Buffers protect against bank downgrades

Rating agencies’ banking outlooks for 2021 are broadly negative, with most banks expected to be impacted to some extent by deterioration in asset quality due to the economic fallout from the pandemic.

However, the majority of covered bonds still have a buffer protecting them from a downgrade in the respective issuer ratings.

Moody’s outlook is negative for 75% of countries where it rates banks, but the proportion of covered bond issuers with stable outlooks has remained high – nearing 80% – albeit declining slightly from 2019.

“In most countries where we rate covered bonds, banks entered the coronavirus crisis with significantly higher capital and liquidity than at the time of the 2008 financial crisis,” they said. “This strong starting position will help banks with the inevitable asset quality and profit deterioration as loan delinquencies increase because of the economic consequences of the pandemic.”

Andrew South, head of structured finance research, EMEA, S&P, said that most of the covered bonds it rates could comfortably withstand a downgrade of the issuer without the programme rating being lowered.

“French and German programmes are generally better protected in this respect,” he said. “Spanish and Italian programmes, on the other hand, typically have less of a buffer to mitigate the effective issuer downgrade, and could also be directly affected if the sovereign rating were to be lowered.”

S&P: Unused notches by country

Source: S&P; Note: Unused notches are the number of notches the issuer credit rating can be lowered by, without resulting in a downgrade of the covered bonds, all else being equal. Data from: Global Covered Bond Insights Q3 2020, 17/09/20.

Fitch meanwhile said the breakeven OC for AAA covered bond ratings for some issuers in Belgium, Canada, France, Germany, Switzerland and the Netherlands rated A+ or AA- on negative outlook would increase if the issuer is downgraded by one notch.

The rating agency has placed most Spanish and Portuguese banks on negative outlook, corresponding with negative outlooks on most cédulas and obrigações hipotecárias (OH) ratings, which are sensitive to any downgrade of bank long term issuer default ratings (IDRs) as they have zero notches of buffer against IDR downgrades.

Directive benefits anticipated, issuance shift mitigated

However, the implementation of the EU Covered Bond Directive – which countries must transpose into national laws by July 2021 – namely, its 180 day net liquidity provision, could result in a payment continuity uplift (PCU) of three notches for cédulas ratings instead of zero currently, said Fitch, offsetting the negative impacts of weakening cover pools.

“The PCU could increase further to six notches should amendments to the cédulas legislation include 12 months’ liquidity protection for principal payments and three months for interest,” they added, “which would mean AAA ratings could be achievable for four of six Spanish programmes, if relied-upon OC is sufficient to support higher rating scenarios.”

As well as the 180 day liquidity rule, the introduction of 12 month maturity extension provisions into the German Pfandbrief Act is expected to increase the PCU for the German product, increasing the buffer against IDR downgrade.

Fitch said in its 2021 outlook that some Danish covered bonds could benefit from a one notch PCU increase if formal provisions to find a refinancing solution without delay in the event of a maturity extension were introduced for certain of the country’s covered bonds, and yesterday (Wednesday) affirmed this, noting that proposed changes to Denmark’s law in this respect will indeed be credit positive and result in a PCU improvement from five to six notches.

“It would affect commercial bank programmes more,” said Fitch, “chiefly by clarifying when a cover pool administrator can be appointed and setting out when it can extend the maturity of a covered bond. This would provide certainty that the covered bond’s maturity could not be extended by the issuer and without seeking refinancing options from the start of the 12-month extension period.”

Covered bonds issued by Danish mortgage credit institutions are unaffected by the change.

Moody’s acknowledged the covered bond directive’s 180 day liquidity buffer as credit positive, as well as its issuer licensing regime, but said other provisions – such as member states having the option to include cover pool assets of lower quality than assets backing most outstanding covered bonds – could potentially prove credit negative.

“Countries may take varying approaches to transposing some parts of the directive,” the rating agency said, “such as the criteria for maturity extensions and liquidity buffer calculations. The new rules will pose particular challenges in Spain, where the legal framework for covered bonds differs from the directive more significantly than other national frameworks, and in Austria, where there are three distinct covered bond laws.”

Most market participants expect benchmark covered bond issuance to remain subdued next year, with issuers again leaning towards central bank funding. The rating agencies highlighted that this could again result in greater asset-liability mismatches, as banks issue shorter dated covered bonds – to benefit from the best terms at central banks – against longer dated assets.

Noting that the average maturity of covered bonds issued around the peak of the crisis in March and April 2020 (which banks mostly retained as repo collateral) was much shorter than for bonds in the same period from 2017-2019, Moody’s said such a trend will increase refinancing risks.

However, while acknowledging such an impact, Fitch also recognised that lower supply in 2021 should support demand for covered bonds.

“This means Fitch is unlikely to change its assumptions in terms of cover pool refinancing risk, which is based on market levels, and which otherwise would also increase breakeven OC ALM loss levels,” it said.

In a report published on Wednesday, the rating agency noted an “ambitious” EU target of reducing by 45% from 1990 levels emissions from buildings by 2030. Moody’s said it expects authorities to gradually transition from encouraging lower energy use to more mandatory regimes.

“As the drive towards energy efficient buildings gains momentum, the risk of property value impairment will increase for buildings that don’t comply with energy efficiency standards,” said Jane Soldera, senior vice president at Moody’s. “Building owners will also face costs to upgrade properties to improve energy efficiency.”

Commercial real estate is under the most pressure, the rating agency said, because EU rules governing the sector are likely to be rolled out with greater urgency and intensity.

However, Moody’s said that covered bond issuers could address the issue in various ways, including scrutinising the energy efficiency of underlying buildings when loans are added to cover pools or renewed.

“Furthermore, green covered bond issuance demonstrates commitment to environmental objectives and increases transparency about the cover pool collateral,” it added.

“Banks can also take advantage of initiatives such as the Energy Efficient Mortgages Action Plan (EeMAP), which provides a framework for banks to fund the purchase and renovation of energy efficient buildings.”

The analysis is one of a series the rating agency has conducted taking an in-depth look at various countries’ legal frameworks, and in a chart summarising the results of these, Slovakia ranked 12th out of 18 jurisdictions, between Norway and the UK.

However, the new jurisdiction ranked 17th when also taking into account market practices, which may occur in a significant proportion of programmes in a country but not be universal.

“Our individual programme research describes programme-specific structure and practice,” Moody’s explained. “We may update this report from time to time as the covered bond framework in Slovakia evolves.

“We may also update our scores as we review our benchmarking of strong, average and weak features across all legal frameworks.”

Among strengths highlighted by Moody’s were: limiting primary cover pool assets to residential mortgage loans secured by property in Slovakia; the law’s mandated covered bond maturity extension periods, potentially for up to two years, that reduce refinancing risk; and a liquidity coverage test that requires coverage of any cumulative liquidity shortfalls in interest and principal on the covered bonds over a rolling 180 days.

“One of the key strengths of Slovakia’s legal framework for covered bonds is that eligibility criteria restrict primary cover pool assets to residential mortgage loans made to consumers,” said Tomas Rodriguez-Vigil, a Moody’s analyst.

“In addition, foreign assets in the cover pools are restricted and liquidity for covered bonds is provided under a specific test.”

One weakness, according to the rating agency, is the lack of specific requirements for frequent tests to manage interest rate and currency risks, despite annual stress testing – although Moody’s said Slovak issuance is likely to be in euros.

Another is cover pool exposure to set-off, due to set-off in Slovakia – in contrast to other countries – operating on a net basis, whereby borrowers would set off mortgage loan obligations against their bank deposits before claiming only the difference from the deposit guarantee scheme.

National Bank of Greece (NBG) issuance off its Global Mortgage Covered Bonds programme – including its outstanding benchmark – were upgraded from Ba2 to Baa1, and issuance off its Mortgage Covered Bonds 2 programme from Ba2 to Baa3.

Covered bonds issued off Alpha Bank AE’s two programmes were upgraded from Ba2 to Ba1. Eurobank Ergasias programme 1 covered bonds – including its outstanding benchmark – were lifted from Ba2 to Baa2, and those issued off programme 2 from Ba2 to Ba1.

The Greek country ceiling was lifted from Ba2 to Baa1 in conjunction with an upgrade of the sovereign from B3 to B1 on Friday. NBG, Alpha Bank and Eurobank Ergasias were upgraded on Tuesday, with their counterparty risk assessments (CRAs) being raised from B3 to B2.

“Today’s rating action on Greek banks was primarily driven by the improving economic conditions and more benign operating environment,” said Moody’s. “The revised bank ratings and outlooks also reflect Moody’s expectation for further improvements in banks’ underlying financial fundamentals through lower level of problem loans, increasing customer deposits and gradual enhancement of their weak profitability.

“The rating agency said that the improvement in the operating environment fundamentally translates banks’ financials being more compatible with a higher rating level.”

NBG’s Global programme rating is now constrained by the country ceiling and the Timely Payment Indicator (TPI) of Probable-High. Eurobank Ergasias’s programme 1 could achieve a Baa1 rating under the TPI framework, but the “committed” overcollateralisation (OC) is only consistent with a Baa2 covered bond rating, Moody’s said.

The rating of NBG programme 2 covered bonds is constrained by their TPI of Probable, and the other three programmes’ ratings are constrained by their TPIs of Very Improbable.

Moody’s also upgraded Alpha Bank Romania yesterday, lifting its deposit ratings from Ba3 to Ba2, on the back of the upgrade of parent Alpha Bank AE. Its CRA was raised from Ba2 to Ba1.

The rating agency said it had incorporated into its analysis a planned EUR200m covered bond that Alpha Bank Romania expects to complete in the first half of the year, noting that the secured funding did not prevent the bank enjoying a two notch uplift from its new BCA to the deposit ratings.

The bank in December announced its plans for what is expected to be the first Romanian covered bond.