s&p global ratings' covered bonds primer · 2019. 6. 20. · covered bonds were first...

S&P Global Ratings' Covered Bonds PrimerJune 20, 2019

This covered bonds primer provides a comprehensive guide to the fundamentals and key featuresof the product.

Let's start with an obvious question…

What Is A Covered Bond?

A covered bond is a debt instrument secured by a cover pool of assets. As long as the issuer issolvent, it is obliged to repay its covered bonds in full on their scheduled maturity dates. If theissuer is insolvent, the proceeds from the cover pool assets will be used to repay the bonds.

Covered bonds were first introduced in Prussia in 1769 by Frederick the Great, and in Denmark in1797. France issued the first "obligations foncieres" in 1852. Despite such a long history, it wasnot until the end of the twentieth century that the size and geographic scope of this marketbroadened considerably, boosted by the introduction of "jumbo" covered bonds in 1995, theintroduction of the euro in 1999, and the approval of dedicated legislative frameworks in a numberof new countries.

Figure 1

S&P Global Ratings' Covered Bonds PrimerJune 20, 2019

PRIMARY CREDIT ANALYSTS

Antonio Farina

Madrid

(34) 91-788-7226

[email protected]

Marta Escutia

Madrid

+ 34 91 788 7225

[email protected]

ANALYTICAL MANAGER

Barbara Florian

Milan

(39) 02-72111-265

[email protected]

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Key Features Of Covered Bonds

- The bond is issued by--or bondholders otherwise have full recourse to--a creditinstitution which is subject to public supervision and regulation.

- Bondholders have a claim against a cover pool of financial assets with a higher prioritythan the credit institution's unsecured creditors.

- The credit institution has the ongoing obligation to maintain sufficient assets in thecover pool to satisfy the covered bondholders' claims at all times.

- The credit institution's obligations in respect of the cover pool are supervised by publicor other independent bodies.

Source: European Covered Bond Council.

The great financial crisis and the European sovereign debt crisis proved that covered bonds can bea resilient source of funding even in times of wider market turmoil, and the amount of outstandingcovered bonds peaked in 2012. Even in the countries most affected by the crisis, such as Italy andSpain, banks were able to access the covered bond market, despite other sources of wholesalefunding evaporating. Issuers and regulators outside the traditional European markets duly notedbanks' ability to issue covered bonds, and expedited the approval or the amendment of legislationgoverning the issuance of covered bonds.

While at the beginning of this century more than 90% of outstanding covered bonds were stillissued out of Germany, Denmark and France, their share had decreased to about 44% by 2017.

Chart 1


S&P Global Ratings' Covered Bonds Primer

What Are The Benefits Of Covered Bonds?

Covered bonds offer significant benefits to issuers and investors, which explain their growingpopularity.

Figure 2



Covered bonds play a systemically important role in Europe

While retail deposits still fund most mortgage lending in Europe, covered bonds play anincreasingly systemic role.

Chart 2



Financial institutions are still the main investors in covered bonds

While private banks and fund managers have historically been the main investors of coveredbonds, central banks have played an increasingly important role, especially following theEuropean Central Bank's decision to include them in its asset purchase program in 2014.

Chart 3

Since financial institutions are the main investors in covered bonds, the legal and regulatoryframework that supervises the financial sector's activity is uniquely important for this market.

The Regulatory Framework

Covered bonds enjoy favorable regulatory treatment compared to many other asset classesbecause of their systemic importance and the relatively low risk profile of the product.

Table 1

Current EU Regulatory Framework

Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive

Article 52(4) provides a common definition for covered bonds

Bank Recovery and Resolution Directive (BRRD)

Article 44(2) exempts covered bonds from bail-in

Capital Requirement Directive (CRR)

Article 129 assigns low risk weights to covered bonds

Liquidity Coverage Ratio (LCR) Delegated Act

Articles 11 to 13 define covered bonds as highly liquid assets



Table 1

Current EU Regulatory Framework (cont.)

Solvency II Delegated Act

Article 180(1) assigns low capital requirements for covered bonds held by insurance and reinsurance undertakings

European Market Infrastructure Regulation (EMIR)

Provides for a specific treatment of cover pool derivatives

Covered Bonds Versus Securitization

The recourse to the issuer and the consequent lack of risk transfer is the main difference betweencovered bonds and asset-backed securities, such as residential mortgage-backed securities(RMBS). Since in covered bonds the credit risk remains with the originator, it has a greaterincentive to manage it prudently. Covered bond programs have dynamic cover pools so that assetsthat repay or which are no longer eligible are replaced, compared to RMBS where the pool isgenerally static and assets are not replaced. Finally, covered bonds tend to have bullet maturities,while in most RMBS principal collections are transferred directly to investors.

Table 2

Key Differences Between Covered Bonds And RMBS

Covered Bonds RMBS

Debt type Typically direct bank debt Debt issued by an SPV

Recourse to the originator Full recourse to the originator No

Tranching All the bonds rank pari passu Senior and subordinated notes

On/off balance sheet On the balance sheet of the originator Off the balance sheet of the originator

Asset pool Dynamic pool Typically static pool

Debt redemption profile Typically bullet Typically pass-through

Replacement of assets Nonperforming assets typically replaced No replacement of nonperforming assets

Covered Bond Program Structures

Legislation-enabled and structured covered bonds

Initially banks only issued covered bonds in accordance with a dedicated legal framework(legislation-enabled covered bonds). The legal framework would define the covered bondprograms' main characteristics, such as eligible assets, minimum overcollateralization, andmonitoring.

From 2003, issuers in certain countries without domestic covered bond legislation, such as theU.K. or the Netherlands, established programs that replicated the main features oflegislation-enabled covered bonds by means of contractual arrangements (structured coveredbond programs). Issuers also sometimes preferred contractual arrangements to gain greaterflexibility outside of an established legal framework.

The legal framework, contractual provisions, or a combination of the two need to effectively isolate



the cover pool assets for the benefit of covered bondholders, so that covered bond paymentscontinue on their scheduled maturity dates. The issuer can achieve this isolation by setting up an"on-balance sheet" covered bond program or through an "off-balance sheet" program.

In "on-balance sheet" programs, the segregation is achieved on the issuer's balance sheet or bythe issuer setting up a distinct subsidiary to hold the cover pool assets (specialist bank model).Covered bond markets with this structure include Austria, Belgium, the Czech Republic, Denmark,Finland, France, Germany, Greece, Hungary, Ireland, Korea, Luxemburg, Norway Portugal, Spain,and Sweden.

Figure 3

In "off-balance sheet" programs, the cover pool is isolated in a special purpose-entity (SPE).Structured covered bond programs are typically set up in this way. However, there are instances oflegislation-enabled covered bonds that use the "off-balance sheet" structure, such as in Italy.Markets setting up SPEs include Australia, Canada, France, Italy, the Netherlands, New Zealand,Singapore, Switzerland, and the U.K.

Figure 4



Participants

There are various parties involved in the effective functioning of covered bond programs, with rolesranging from the origination of cover pool assets to the repayment of the covered bonds. Thenumber and functions of the parties may vary by program.

Figure 5

Maturity structures

As long as the issuer is solvent, it is obliged to fully repay its covered bonds on their scheduledmaturity dates. If the issuer is insolvent, it will apply the proceeds from the cover assets to repaythe covered bonds.

In a traditional "hard bullet" structure, the pool administrator may need to liquidate collateral to



repay the bonds on time, on their scheduled maturity dates. By contrast, in a "soft bullet"structure, the pool administrator can extend the maturity date, typically by up to a year, before thecovered bonds become due and payable. This postpones the liquidation of the assets, and canhelp avoid forced sales.

Conditional pass-through (CPT) structures typically switch to a pass-through redemption profileafter an issuer insolvency, when either the assets in the pool offer insufficient funds to repay thecovered bonds, or a performance test has been breached. In a pass-through redemption, theissuer applies collections from the assets on each payment date to repay the principal on thenotes, but the trustee does not need to liquidate the assets, because the maturity of the notes canbe extended. The extension date typically depends on the remaining term of the assets, whichcould enable the issuer to hold the assets to maturity while retaining the option of liquidatingassets in advance if market conditions are favorable. An amortization test will typically limit theamount of assets that the issuer can sell to repay any bond series, therefore mitigating the riskthat investors in the longer-dated notes rely on insufficient assets to repay them.

Figure 6

Cover Pool Assets

Cover pool assets generally comprise either mortgage loans or public sector loans, and in morelimited instances, shipping or small and midsize enterprise (SME) loans. Both residential andcommercial loans can be included in cover pools. Public sector lending typically includes loansto--or guaranteed by--national, regional, and local authorities. Cover pools may also comprise alimited percentage of substitute assets, such as bank accounts or highly rated securities forovercollateralization or liquidity purposes.

By the turn of the century, covered bonds were mainly backed by public sector loans, but sincethen, mortgage loans have gained more market share. This was due to the reduced supply ofassets eligible for German public sector covered bond programs following the withdrawal of publicsector guarantees from state-owned banks (Landesbanks), and that debt issued by saving banksis no longer eligible.



Chart 4

While the range of eligible cover pool assets for legislation-enabled covered bond programs isdefined in the country-specific covered bond framework, structured covered bond programsnormally define a set of eligibility criteria contractually. These eligibility criteria aim at ensuringminimum standards of portfolio credit quality, including maximum loan-to-value (LTV) ratios andrestrictions on property locations.

Coverage Tests

The cover pool's ability to repay covered bonds on time after the issuer's insolvency can bechallenged by a number of factors, such as a spike in defaults in the portfolio or liquidity shortfallsresulting from asset-liability mismatches. To mitigate such risks, covered bond issuers may besubject to minimum mandatory overcollateralization levels, whereby the asset balance generallyneeds to exceed the amount of covered bonds by a determined level. The minimumovercollateralization levels as well as the calculation methods vary by jurisdiction.

Table 3

Overcollateralization Levels Vary Across Jurisdictional Frameworks

Denmark Germany Greece Spain U.K.

Minimum mandatory O/C 8% 2% 5.26% 25% 8%

Basis of calculation Risk weighted assets Net present value Nominal value Nominal value Nominal value

The breach of the minimum mandatory overcollateralization level has different consequencesdepending on the legal framework. These may include the revocation of the issuer's license toissue covered bonds, the suspension of the program, the redirection of cash flows.

In structured covered bond programs, issuers typically commit to a minimum level ofovercollateralization via contractual asset coverage tests (ACTs).

These tests are designed to not only ensure a minimum ratio of cover pool assets for coveredbonds, but also serve to enhance the credit quality of the assets in the portfolio, by excluding



impaired assets from the amount of eligible assets and therefore creating an incentive for issuersto remove them from the cover pool.

Figure 7

The "adjusted cover pool balance" is generally calculated by subtracting, from the principalbalance of cover pool assets, loans in arrears or loans that do not meet certain eligibility criteriasuch as maximum LTV ratios. The "adjusted cover pool balance" is then multiplied by the assetpercentage (AP), the result of which will determine the maximum amount of covered bonds thatcan be issued.

Compliance with the ACT is assessed periodically, typically monthly, and the breach of the testwithout cure normally triggers an issuer's insolvency.

Following the issuer's insolvency, the amortization test monitors the covered bond program'scredit enhancement. The mechanics and calculation of this test is similar to the ACT and itspurpose is to ensure that all outstanding covered bonds equally benefit from a minimum level ofovercollateralization.

Covered bond programs may include other tests in their structure, such as the net present value(NPV) test or the interest coverage test. The NPV test typically ensures that the NPV of the coveredbonds is less than or equal to the cover pool's NPV, while the interest cover coverage test aims toensure that the expected interest inflows from the portfolio will exceed the interest payments onthe bonds for a pre-determined time period.

S&P Global Ratings' Analytical Approach

S&P Global Ratings' credit ratings are designed primarily to provide a forward-looking opinionabout the relative rankings of overall creditworthiness among issuers and obligations.

In an indirect way, our consideration of absolute default likelihood can be viewed as associatingstress tests or scenarios of varying severity with the different rating categories. For example, wewould expect issuers or securities with higher ratings to withstand more severe macroeconomicscenarios without defaulting. Those rated lower would generally have less capacity to withstandthese more severe scenarios. In other words, the higher the rating category, the more severe thestress level associated with that category.

Table 4

S&P Global Stress Scenarios

Ratinglevel Description

Unemployment rate(%)

GDP decline(%)

Stock marketindex decline (%) Examples

'AAA' Extreme stress >20% >15% >70% Great Depression, 1929 (U.S.); GreatDepression, 1937 (U.S.); andArgentine economic crisis (1998)

'AA' Severe stress 15%-20% 6%–15% 60%-70% Panic of 1837 (U.S.) and Thai currencycrisis (1997)



Table 4

S&P Global Stress Scenarios (cont.)

Ratinglevel Description

Unemployment rate(%)

GDP decline(%)

Stock marketindex decline (%) Examples

'A' Substantialstress

10%-15% 3%-6% 50%-60% Panic of 1907 (U.S.) and LatinAmerica debt crisis (1981)

'BBB' Moderatestress

8%-10% 1%-3% 25%-50% 2008-2009 credit crisis (U.S.);Japanese bubble (1989); and early1990s recession (U.K.)

'BB' Modest stress 6%-8% 0.5%-1% 10%-25% 2001 recession (U.S.) and early 1980srecession (U.S.)

'B' Mild stress <6% 0%-0.5% 0%-10%

Our covered bond ratings process follows the methodology and assumptions outlined in our"Covered Bonds Criteria," published on Dec. 9, 2014, and "Covered Bond Ratings Framework:Methodology And Assumptions," published on June 30, 2015. For a full description of ourmethodology, please refer to these criteria.

We organize our analytical process for rating covered bonds into four key stages:

- Perform an initial analysis of issuer-specific factors--legal and regulatory risks and operationaland administrative risks--which mainly assesses whether a rating on the covered bond may behigher than the rating on the issuer;

- Assess the starting point for the rating analysis based on the relevant resolution regimes;

- Determine the maximum achievable covered bond rating based on an analysis of jurisdictionaland cover pool-specific factors; and

- Combine the above results and incorporate any additional factors, such as counterparty riskand country risk, to determine the final covered bond rating.

Figure 8



Step 1: Initial analysis

The primary aim of the initial analysis of the covered bond ratings framework is to determinewhether the covered bond rating may exceed the rating on the issuer. Due to the dual-recoursenature of covered bonds, the covered bond rating is typically no lower than the relevant rating onthe covered bond issuer.

Legal and regulatory risks

The assessment of legal and regulatory risks focuses primarily on the degree to which a coveredbond program isolates the cover pool assets from the bankruptcy or insolvency risk of the coveredbond issuer. If the asset isolation analysis concludes that covered bonds are not likely to beaffected by the bankruptcy or insolvency of the issuer, then we may assign a rating to the coveredbonds that is higher than the rating on the issuer.

Operational and administrative risks

The analysis of operational and administrative risks focuses on key transaction parties to assesswhether we consider they would be capable of managing a covered bond program for as long asany bonds issued remain outstanding. The key transaction party in a covered bond program istypically the issuer, which originates, underwrites, and services the cover pool assets. In order topotentially assign a rating on the covered bonds that is higher than that on the issuer, the analysisconsiders the possibility that the covered bond issuer may be unable to perform its duties in thefuture and contemplates the likelihood of a successor servicer being appointed.

Step 2: Determination of the reference rating level

For ratings on covered bonds that may exceed those on the issuer, as we determine according tostep 1, we then proceed to step 2, to determine the starting point for our analysis or referencerating level (RRL). This reflects the likelihood that the issuer can service the covered bonds fromits own funds. In general, the RRL is at least equal to the issuer's issuer credit rating (ICR).

Furthermore, certain resolution schemes, although their purpose is to limit government support tofailing banks, also provide for a more protective status for covered bonds than for most otherliabilities of the bank. This is the case of the EU's Bank Recovery And Resolution Directive, forexample. In this case, we consider it possible that an issuer may continue to service protectedliabilities, such as covered bonds, even though it may default on other types of liabilities. Wetherefore may assign an RRL up to two notches higher than the ICR, reflecting what we believe isthe effect of the resolution scheme on the issuer's ability to make payments on the covered bonds.

Step 3: Determination of the maximum achievable covered bond rating

If the issuer defaults and is not restored as a going concern following a bank resolution, thecovered bond program would turn to sources other than its issuing bank to meet payments dueand to mitigate its refinancing risk. The aim of this third step of the covered bond ratingsframework is to determine the maximum achievable covered bond rating, i.e., the rating level thatis consistent with the available credit support to achieve repayment on the covered bonds.



Jurisdictional support

In our jurisdictional support analysis, we assess the likelihood that a covered bond facing stresswould receive support from a government-sponsored initiative instead of from the liquidation ofcollateral assets in the open market.

Our assessment of jurisdictional support is based on: 1) the strength of the legal framework; 2) thesystemic importance of the covered bonds in their jurisdiction; and 3) the sovereign's creditcapacity to support the covered bonds. Based on the above factors, we establish a four-pointclassification of jurisdictional support: very strong, strong, moderate, and weak. Depending on ourassessment, the criteria provide for potential rating uplift of up to three notches above our RRL ofthe covered bond.

To the extent that we give credit to jurisdictional support in our analysis, ourjurisdiction-supported rating level (JRL) is capped at the foreign currency rating on the country inwhich the covered bond issuer is based.

Collateral support

We then consider to what extent overcollateralization enhances the creditworthiness of a coveredbond issue by allowing the cover pool to raise funds from a broader range of investors and soaddress its refinancing needs. This overcollateralization may cover the credit risk only, theexpected losses incurred by the cover pool in a stressed scenario, or also the refinancing costs,that is, the additional collateral required to raise funds against its assets to repay maturingcovered bonds. We refer to this as "collateral-based uplift".

The "maximum collateral-based uplift" for a given covered bond program depends on our viewabout the presence of active secondary markets for the assets in the cover pool (to enable thecovered bond to raise funds against its assets):

- We may allow up to four notches of collateral-based uplift above the JRL forovercollateralization covering credit risk and refinancing costs where we believe activesecondary markets exist to enable the covered bond to raise funds against its assets; or

- We may allow up to two notches of rating uplift above the covered bond's JRL forovercollateralization to cover credit risk only, in jurisdictions that we believe do not have asufficiently active secondary market to enable the covered bond to raise funds against itsassets.

Our analysis of the covered bonds' payment structure considers whether cash flows from thecover pool assets would be sufficient, at the given rating, to make timely payment of interest andultimate principal to the covered bond on its legal final maturity date.

We also consider whether the overcollateralization is committed or voluntary, and whetherliquidity is available for managing market-based refinancing strategies. The uncommittedovercollateralization or lack of committed liquidity may reduce the collateral-based uplift.

Step 4: Additional factors

The aim of the fourth and final stage of the covered bond ratings framework is to determinewhether considerations not directly related to the covered bond issuer and covered bond programwould limit the maximum achievable covered bond rating (based on the previous two stages). This



stage assigns the final covered bond rating after considering the impact of these additionalfactors.

Counterparty risk

Counterparty exposure is an important factor when assessing a covered bond program's creditrisk because a counterparty's failure to perform on its obligations may lead to a payment defaulton the bonds. The analysis focuses on obligations arising from third parties that either hold assetsor make financial payments that may affect the creditworthiness of covered bonds. Typicalexamples of entities posing counterparty risk in covered bonds are the parent or related entities,bank account providers, and derivative counterparties.

Country risk

The country risk analysis considers sovereign and country risks for the jurisdiction of the assetsand the issuer. Our structured finance ratings above the sovereign criteria determine a maximumrating differential above the long-term sovereign rating as a function of the underlying assets'sensitivity to country risk and the sensitivity of the covered bond structure to refinancing risk. Wecategorize the underlying assets' sensitivity to country risk as high, medium, or low and thencombine the assessment with the covered bonds' exposure to refinancing risk to assess themaximum differential above the sovereign rating.

Table 5

Covered Bonds Sensitivity To Sovereign Default Risk

Based on our assessment of refinancing risk

Sovereign default risk sensitivitybased on our assessment ofrefinancing risk Mitigation of refinancing risk

Maximum differentialabove the sovereign rating(notches)

High Covered bonds issued in a country that is not a member ofa monetary union, that do not include structural coverageof refinancing needs over a 12-month period

Two

Moderate Covered bonds issued in a jurisdiction that is within amonetary union, that do not include structural coverage ofrefinancing needs over a 12-month period

Four

Moderate Covered bonds issued in a country that is not a member ofa monetary union, that include structural coverage ofrefinancing needs over a 12-month period

Four

Low Covered bonds issued in a jurisdiction that is within amonetary union, that include structural coverage ofrefinancing needs over a 12-month period

Five

Low Pass-through or conditional pass-through covered bonds Six

Structural mechanisms to cover refinancing needs over a 12-month period can include liquidityreserves, in which upcoming maturity payments are pre-funded, or extendible maturities.

Where a program has outstanding foreign-currency-denominated covered bonds, the ratings onthe covered bonds may be constrained by our transfer and convertibility (T&C) risk assessment.Our T&C assessment reflects our view of the likelihood of a sovereign restricting access to foreignexchange needed to satisfy debt service obligations. Unless there are structural mitigants for T&Crisk in place, such as a political risk insurance or third-party guarantees, we would cap the ratings



on the covered bonds at the country's T&C assessment.

Chart 5

Related Criteria

- Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019

- Sovereign Risk In Rating Structured Finance Securities: Methodology And Assumptions, Jan.30, 2019

- Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015

- Covered Bonds Criteria, Dec. 9, 2014

Related Research

- Global Covered Bond Characteristics And Rating Summary, published quarterly

- Global Covered Bond Insights, published quarterly

- Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019

- Covered Bonds In New Markets: Research By S&P Global Ratings, March 21, 2019

- Glossary Of Covered Bond Terms, April 27, 2018

This report does not constitute a rating action.





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