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Never have, never will? The Covered Bond Blog

23 February 2015
Richard Kemmish

No covered bond has defaulted in 237 years. We recite the mantra, it may or may not be true, it is of course irrelevant.  But, we recite it anyway.

Why is it irrelevant? Mainly because of the new relationship between tax payers and the banking system exemplified by the bank recovery and resolution directive. We tend to think of the resolution directive as an unalloyed good for covered bonds, which it is of course. But it also exemplifies a fundamental change in the relationships at the core of that long track record. Covered bonds have never defaulted because they have never been tested because the taxpayer has always been there. No more.

As we think about whether the covered bond winning streak will extend into its 238th straight year a timely piece of research has just been published by Moody’s on covered bond rating migration. In the absence of empirical evidence on defaults, look for empirical evidence on the step towards a default, a downgrade.

Of course there have been plenty, as documented by Moody’s the covered bond market had several years where downgrades significantly outnumbered upgrades. That period is over (for now?) and the covered bond market has returned to its pre-2008 state of upward rating momentum.

Would it be fair to call that the natural state of the covered bond market? I would argue yes. Before the crisis the covered bond market was overwhelmingly Aaa rated, and yet upgrades still heavily outnumbered downgrades. Improved technology was the only reason for this and technology can’t be uninvented.

But what of the downgrade years? Moody’s provide some very helpful statistics. Firstly that covered bonds are half as likely to be downgraded as unsecured debt. This is not perhaps too surprising, given the overwhelming Aaa nature of the market. Not only were most bonds Aaa, most were ‘Aaa with notches to spare’. Often several downgrades of unsecured debt were needed before the covered bonds were effected. Naturally the unsecured:covered downgrade ratio has deteriorated as the crisis wore on and the cushions became less plump. 

But this also points to another important fact, and the most useful statistic in the Moody’s report: 98% of covered bond downgrade were preceded by an issuer or sovereign downgrade in the previous 6 months.

Lets just think about the implications of that. Almost no covered bonds were downgraded because of anything to do with the covered bond per se. They were only ever downgraded because of external factors.

It’s a big if but if you can isolate covered bonds from sovereign risk (Lord Hill) and if the bank recovery and resolution directive works and TLAC buffers are as regulators want them to be covered bond ratings will increasingly depend on endogenous, not exogenous factors (the ratings of securitisations are of course like that, but with exactly opposite results).
As Moody’s has demonstrated this will be an overwhelming positive. Not only no defaults, but also almost no steps towards a default.

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