End of an erAAA

IFR Covered Bonds 2009
9 min read

A new threat to the covered bond recovery has emerged in the form of the rating agencies. New rating proposals from S&P pose a risk that up to 60% of covered bonds could lose their Triple A status, while Fitch might downgrade up to 5% of public sector and 10% of mortgage covered bonds. Andrew Perrin investigates where the agencies are in the process, and what impact the proposals would have.

Standard & Poor's new methodology proposal for covered bonds will have issuers everywhere on red alert. If implemented, they could see the credit ratings of more than half of Europe's covered bonds come under pressure. The news is obviously negative for the product, but the changes will essentially link the rating of the issuer with the covered bonds themselves. This will bring S&P’s methodology into alignment with those of Moody's and Fitch.

S&P estimates that approximately 60% of the programmes by number would not meet the proposed minimum rating guidelines for covered bond issuers. A large number of the bonds would also have to increase their over-collateralisation to maintain current ratings. The proposals would put more emphasis on the ability of covered bonds to access liquidity to repay investors in the event of an issuer default. While S&P has not downgraded any covered bonds so far, such actions would become more frequent as the ratings of issuers came under pressure, said Karen Naylor, head of European covered bond ratings at S&P.

"In proposing a new methodology for rating covered bonds, S&P finally says goodbye to the ‘de-linked’ rating approach," said Heiko Langer, a covered bond strategist at BNP Paribas. "De-linking the covered bond rating from the issuer rating has been a key point of differentiation of S&P's methodology from that of Moody’s and Fitch."

When S&P initially made the announcement earlier this year, the agency requested market feedback on the proposal during a period that was extended until March 27. The agency was still digesting what it described as an extensive and detailed response from the market when this report was filed, much of which was quite critical of the proposals according to market sources. There was no official date earmarked for further announcements as the report went to press.

Regarding liquidity risk

Fitch Ratings has also been reviewing its procedures, particularly with regard to how it evaluates the sticky subject of liquidity risk within covered bond programmes. Overall, the proposed amendments would lead to a tighter relationship between the issuer default rating of a financial institution and its covered bond rating. The level of over-collateralisation between the cover assets and covered bonds in line with a given rating scenario is expected to increase.

Other aspects of the Fitch covered bonds rating methodology remain unchanged. Notably, covered bond ratings will continue to reflect the probability of default of the instrument, as well as stressed recoveries from the cover pool in the event of a default.

"Since the onset of the global financial crisis, banks' funding sources have dwindled dramatically. This lower certainty attributed to asset liquidation in a given timeframe will be reflected in changes to Fitch's Discontinuity-Factor scoring," said Helene Heberlein, head of covered bonds at Fitch.

The agency finished its six-week consultation period on April 30 and is expected to publish revised criteria that will take into account new liquidity assumptions later this month. That could result in the downgrade up to 5% of public sector and 10% of mortgage covered bonds.

Meanwhile, the prospect of lower ratings could take the gloss off the recent announcement from the ECB, which stated it would provide unprecedented support for covered bonds in the form of a €60bn buy-back. Issuance in the jumbo sector has soared since the announcement, and at €16.25bn as the report went to press, fresh supply in May comfortably surpassed the total volume of benchmarks priced during the first four months of the year combined.

At best the continuing moves by the leading agencies to tighten criteria could mean that obtaining the top rating may become more expensive for issuers as more over-collateralisation is required. At worst the covered bond market's status as a Triple A arena could be eradicated.

Not to be outdone and with scythe in hand, Moody's also warned recently that a mass cull of Cedulas ratings was on the cards in the first wave of a sweeping overhaul of covered bond ratings. Following the action it had taken on the underlying Spanish institutions supporting the covered bonds, the agency placed on review for downgrade the Aaa ratings of no fewer than 57 series of Spanish covered bonds issued under multi-issuer covered bond programmes, and of some seven mortgage bond and four public sector covered bond programmes.

Moody's was the last of the three main ratings agencies to adjust its rating models to take into account refinancing risks, though the lion's share of the 58 programmes affected would only require an additional 5% over-collateralisation.

A ratings bloodbath?

It is S&P's proposed changes that have the greatest potential for ratings carnage. The market was always aware that the rating agencies were examining their methodologies, but had put it to the back of its collective mind and instead rode positive momentum created by the ECB's action. While it is still uncertain whether the initial proposals will come to fruition, a large number of downgrades would appear to be on the cards regardless.

"There has already been a great deal of speculation surrounding the forced selling argument, as some investors – mainly central banks – will not be able to hold covered bonds should they lose the Triple A rating" said BNP’s Langer. Yet this investor-type comprises a small percentage of the overall market, he stressed, with many of those who would be affected understood to have already reduced their holdings. The direct impact on spreads is therefore unlikely to be too severe, he added.

"This amount of downgrades will undoubtedly put some pressure on spreads, although a notable sell-off would be unlikely,” Langer said. “If you look at the [covered bond] market, it has already anticipated much of this ratings divergence, reflected by the fact that Triple A rated covered bonds have traded at a spread differential of up to 60bp across European markets already this year. The credit quality of the issuer and rating at unsecured level has been the main driving factor behind this. Indeed, we have actually seen spreads begin to narrow in recent weeks on the ECB's announcement."

Meanwhile, Franz Rudolf, head of financials credit research at Unicredit, does not expect S&P to push through its initial plans due to what he described as "the bloody nose that they received from issuers and investors alike." They should instead follow up with a second proposal in order to save their credibility, he said.

He agreed that the forced selling argument is probably overdone, given the size of this specific investor base. "If you look at the German Pfandbriefe market for example, there are Double A issues such as the mortgage Pfandbriefe of Berlin Hyp that are trading tighter than some of their Triple A rated peers. This stems to a large extent from the credit specific news flow that is never more significant than during a crises, while other factors such as rarity value and liquidity could also play a part," he said. Any downgrade driven move in spreads should be limited and quickly stabilize, he added.

Still, the development could drive the differential between Double A and Triple A securities wider over all, which in turn could hamper the ability of some issuers to access the market. "We have seen a huge wave of issuance recently post ECB, although this has mainly stemmed from more stable issuers with better senior, unsecured ratings,” said Langer. “ This is in contrast to markets such as the UK and Ireland that have been closed for the longest period and any fallout from these downgrades is unlikely to help what is already a rocky road back to the market ".

From an investor perspective, Torsten Strohrmann, senior portfolio manager at DWS Investments, suggested that losing its near exclusive Triple A status and moving more towards a Double A to Triple A market could leave some investors behind. Many others, however, and among them DWS, can invest in Double A securities, providing their clients agree. "Nothing has changed where the cover pool is concerned,” he said. “This is more the result of an increase in the level of cautiousness of the rating agency, and one has to decide if this view is appropriate for oneself or not."