Analysts believe that up to 40% of the covered bond market could become non triple A within a year, compared to around 10% today. The potential ratings onslaught is being driven by the unrelenting pressure on sovereign bond ratings. Added to that, state support for smaller and systemically less important banks is no longer taken for granted.
If that wasn’t enough, agencies are increasingly nervous about underlying swap agreements. They are tightening their criteria.
The loss of triple A status means that a large section of the covered bond buyer base will stop investing in the asset class. The incoming Solvency II regime will make it extremely expensive for insurance companies to hold covered bonds on their balance sheet if the securities are rated below triple A. And central banks are usually mandated to only buy the highest rated bonds.
For a market that once prided itself on being a low risk, top grade rates product, the prospect of ratings downgrades suggests that covered bonds could be set for a devastating blow.
The truth is a bit different. Despite this fall away in traditional demand, the market has become less reliant on these established pockets of buyers. Instead it is increasingly moving towards a new breed of credit fund buyers — who don’t necessarily need a top rating.
Moreover, bank credit investors, who have yet to really increase their covered bond purchases, should soon step up their buying. This is because Basel III and the Capital Requirements Directive IV endorse covered bonds as the only bank funding instrument eligible for bank liquidity buffer purposes.
The upshot is that both the ratings of covered bonds, and its investor base, look set for massive change over the next year. With the buy and hold mindset likely to become a less significant part of the whole, it is probably fair to conclude that this new breed of investors will be more tuned in to relative value.
And because their investments will be less determined by the need to match up their long term liabilities, they will be more inclined to churn the market. The result will be double-edged. Yes, the market will be structurally more liquid than it has been. But it will also be more volatile.