The rating of a covered bond can never be entirely immune from its issuer. But the connection is now less material than it ever was. This is because Europe’s draft bank Recovery and Resolution Directive explicitly excludes covered bonds from a bank’s resolution process.
In spite of this, covered bond ratings remain resolutely sensitive to their issuer’s rating. Nowhere is this more conspicuous than in the periphery, where sovereign downgrades have pummelled issuers’ credit ratings, severely hitting their covered bond ratings.
The link is most visible under programmes rated by Moody’s. One third of all the covered bond programmes that this agency rates would be downgraded if the issuer were to be downgraded. Another third would be downgraded if the issuer were taken down by more than one notch.
This hardly makes sense. Fitch says the exclusion of covered bonds from bank resolution should, in theory, widen the difference between the ratings of covered bonds rating and senior unsecured debt.
Fitch makes an important distinction between an issuer’s senior unsecured rating and its Issuer Default Rating (IDR). It points out that while the senior unsecured rating incorporates expectation of recoveries given default, the IDR indicates an entity’s vulnerability to default and is therefore independent of the recovery given default.
The agency reckons that the IDR is the appropriate reference for covered bond ratings given that bondholders’ first recourse is to the issuing institution. But it reserves the ability to depart from this “once there is greater visibility of the type of default an institution is likely to suffer”.
Take Cyprus. Fitch no longer uses the IDR as its starting point for assessing covered bond risk there, since the instruments had access to “established liquidity provisions” and were not expressly included in bail-in when the country’s banks were tottering earlier this year.
But for the moment, that treatment is the exception rather than the rule. Fitch is worried that individual bank resolutions are likely to be bespoke and that investors’ claims on voluntary overcollateralisation do not yet benefit from a cast iron guarantee in all regimes.
That concern is misplaced: it’s already clear that covered bonds and the mandatory minimum overcollateralisation are protected from resolution.
The rating agencies will eventually wake up and come to the conclusion that a much wider notching span to the issuer’s rating is fully justified, especially in regimes where national regulators have explicitly protected voluntary OC.
Unfortunately this may not come quickly enough to prevent a few more deals being downgraded to junk. That will bring out forced sellers, causing mark-to-market pain — and more selling.
Covered bonds are excluded from bank resolution regimes; senior unsecured bonds are not. The first rating agency that acknowledges this reality and changes its methodology to reflect it will be rewarded with an increase in market share that should incentivise the others.