S&P discovers that collateral backing covered bonds is important

Tracy Alloway at the Financial Times wrote an article on S&P cautioning investors to distinguish between covered bonds based on the loans supporting them.

Regular readers know that your humble blogger introduced this idea several months ago while discussing the problems with covered bonds.  The solution is to provide market participants with current loan-level performance data so they have the ability to analyze the supporting loans.

Covered bonds are not the universally safe assets that some investors think they are, rating agency Standard & Poor’s has warned in a new report. 

“There remains a tendency for investors to treat all covered bonds as alike in credit terms, which we believe is not the case,” S&P’s Karen Naylor said. The report, called ‘Never underestimate credit risk in mortgage bonds’, argues that the riskiness of the loans underlying the bonds can vary significantly from deal to deal. 

Sales of covered bonds have boomed in recent months, with about €1,000bn of the debt now outstanding in Europe alone. The bonds are gaining in importance since, for many European banks, they remain the only source of funding amid eurozone turmoil. Unsecured debt issuance, traditionally the biggest funding tool for Europe’s banks, has dried up since July, leaving covered bonds to plug some of the gap... 

Many investors consider the bonds “super-safe” because, if the underlying assets sour, they also have a claim on the issuing bank. However, in the report, S&P warns that “the common perception of mortgage covered bonds as a homogeneous and universally low-risk product is misleading. In fact, the characteristics of individual mortgage covered bonds are not only diverse, but can change over time.” 

Covered bonds are typically backed by either mortgages or government-related loans, the analysts explained. The bonds remain on issuing banks’ balance sheets, unlike other forms of structured finance such as mortgage-backed securities. Moreover, the issuer must “top up” the bonds if underlying loans go bad, meaning the assets backing the debt can vary, within certain legal boundaries. 

In covered bonds comprised only of mortgages, for instance, there may be a mix of residential and commercial loans. In covered bonds backed by public sector debt, there may be a mix of exposure to different governments, S&P said. 

Investors in what appears to be staid public sector Pfandbriefs, as German covered bonds are known, may be surprised, for example, to find the bond also contains loans to civil servants in Greece. Barclays Capital estimated last year that 10 per cent of the assets in public sector Pfandbriefs are exposed to European peripherals, though that figure is likely to have altered significantly since then. 

The report comes just as the covered bond industry grapples with record issuance and a wider international roll-out. The Association of German Pfandbrief Banks, for instance, has warned that new proposals for covered bonds in the US, which may use student or car loans as collateral, will damage the debt’s reputation.