Covered bonds are a circa €2,000bn market.
Europe is the biggest issuer of such debt.
And Europe is in trouble.
To date because of their unique structure, the fortunes of covered bonds have been only loosely-tied to those of their issuers, at least in terms of ratings. That means that the bonds usually get higher ratings than their issuers since (unlike in securitisation) the assets stay on the issuer’s balance sheet and are ring-fenced to give investors some protection in the event of issuer bankruptcy.
But that might be about to change.
Standard & Poor’s caused not-a-little controversy when it proposed changing its covered bond rating methodology to link the bonds’ ratings more closely with that of the issuer. And it looks like Moody’s is also suggesting a stronger link.
From a Moody’s report released late Thursday:
Issuer rating actions will remain the prime driver of covered bond ratings in 2010, especially given that most issuers’ ratings are either on review for possible downgrade or have a negative outlook.
Going forward, downgrades of issuers’ ratings are more likely to result in downgrades of their covered bond ratings than has been the case to date. This is because many issuer ratings are falling closer to key Timely Payment Indicator (TPI) thresholds.
Put simply, Moody’s TPI assesses expected losses for covered bondholders following an issuer default, and also limits the covered bond rating to a certain number of notches above the issuer rating.
And the importance of the TPI methodology seems to be growing:
The large majority of ratings are at present determined solely by Moody’s EL Model because for most programmes, the rating on the covered bonds is currently not restricted by the TPI. However, the relevance of Moody’s TPI framework is increasing. At the start of 2009, the covered bonds of 13 programmes would have been subject to a rating downgrade if the issuer rating fell by a single notch. By the end of 2009, this number had increased to 34 (18% of total rated).
According to Moody’s it definitely can:
At the start of 2010, five countries in which Moody’s rates covered bonds face a negative sovereign outlook. These are: Greece, Hungary, Ireland, Latvia and Portugal. The sovereign outlook for other countries with covered bond issuers was stable.
As seen in 2009, a negative rating action on a sovereign may adversely impact covered bond ratings. Downgrades of sovereign ratings may negatively impact covered bonds directly, as refinancing risk in a market increases, or indirectly, to the extent the downgrade may lead to negative rating pressure on covered bond issuers.
If sovereign weakness translates into government rating downgrades, this could be an important driver for covered bond ratings in the year ahead.
It’s worth noting that Moody’s said on Thursday it’s reviewing Greek structured finance transactions and covered bond ratings. Triple-A ratings for the Greek stuff appear high compared to the A2 rating the agency now assigns to Greek government bonds, the agency said (ahem).
That sovereign uncertainty is something that’s possibly already beginning to feed through into other parts of the covered bond market.
This chart, from Deutsche Bank, is instructive. It shows the covered bonds of Spain, where macroeconomic worries are beginning to gather pace, in particular, starting to underperform compared to say German pfandbriefe or French bonds:
The Spanish covered bond (cedulas) market alone is worth around €330bn.
About €30bn of it will need to be refinanced in 2010, according to Deutsche.