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Good in bad or bad in good?

15 August 2014
Richard Kemmish


Would you rather have the best credit in a badly rated country or the worst credit in a well rated country?

Everything so far suggests the former. Whilst the equity of national champions of southern Europe might not have been a good place to be, as you go further up the credit spectrum it gets better. Until you arrive at covered bonds where the credit has remained pristine (it’s worth taking a look at the Bank of Ireland cover pool for an example). In other words failures, when they happen, have been idiosyncratic not systemic.

A bank can’t perform in a poorly performing economy – hence the poor equity performance. But it can survive, particularly in a country which can’t afford a banking crisis and will therefore do whatever it takes, as Spain has repeatedly shown.

The latest casualty, Banco Espirito Santo, could therefore be seen as a sign of Portugal’s recovery. Like SNS in the Netherlands it has failed without any significant repercussions for its peers of for its sovereign credit. The market just shrugged it off. That would not have happened even one year ago, let alone in the height of the crisis. 

But what does this have to do with covered bonds?

According to Moody’s 56 covered bond programmes have ratings that are capped by the country they are situated in. This applies in 11 countries, 8 of which are in the euro zone.  There are three reasons for this, two of which are real concerns but which might turn into a buy opportunity. One of is unequivocally an indicator to buy.

The real concerns are the so-called sovereign ceiling – the highest you can get in a country and the timely payment indicator – an input to the Moody’s model that combines with the issuer’s unsecured rating to derive their covered bond rating. The fact that the unsecured rating of the issuer is itself closely linked to the sovereign rating in most cases suggests that these two should be pretty closely related.

What is slightly counterintuitive then is that in some countries (like Italy) the sovereign cap is the only constraint on covered bond ratings whilst in others (like Portugal) the TPI is the binding constraint. This is simply a function of the better credit worthiness of banks than the sovereign in Italy and their strong correlation in more homogenous Portugal.

Which leads to one of my two ‘buy’ signals. Europe is going to become increasingly like Italy and unlike Portugal as a result of the European Banking Union, to the extent that it decreases the sovereign/banking credit nexus.

The second buy signal is a result of the other main way in which the sovereign influences the covered bond – the quality of the assets in the pool. But in the covered bond world we’ve got this one sorted, as Bank of Ireland demonstrates (told you it was worth taking a look at).
 
So for me, its good pool in a poorly rated country every time.

Anyone in Germany want to disagree with me?

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