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Better than the government?

01 December 2016
Richard Kemmish

Normally I write for Euromoney Conferences about my first love – covered bonds. Occasionally though they also ask me to comment on my second love – central and eastern Europe, something that I have been introduced to by my first love. Whilst the overlap – covered bonds in the CEE region - is an important, vibrant and fascinating area there are wider lessons to be drawn from the western European covered bond market for central and eastern Europe. I’d particularly highlight credit ratings.

One of the big problems shared by the western European covered bond market and the eastern European credit market is the nexus between high credit quality private sector bonds and sovereign ratings. Whilst the rating agencies have tied the two closely in the case of covered bonds from the so-called ‘peripheral’ countries of Southern Europe, the market disagrees.

A very large portion of covered bond downgrades through the crisis have been a direct result of a downgrade of the country from which they originate. According to the rating agency methodologies there are many ways in which sovereign credit can infect covered bond credit – the macro-economic environment will deteriorate as a result of the government’s woes, the banks will find it more difficult to refinance maturing bonds, the banking system will be less profitable and, worst of all, a default might be imposed on private sector issuers via, for example, the imposition of capital controls.

In practice though the credit quality of the vast majority of mortgage covered bonds in the effected countries, arguably all of them, has remained impeccable. The creditworthiness of bonds issued by Greek or Irish mortgage banks for example have frequently surpassed those issued from Germany or Holland. There are many possible reasons for that, good financial technology or the fact that the average homeowner is more trustworthy than the average politician, for example. But I think that the real reason is that the worse the credit rating of a country, the more issuers in that country take the steps needed to ensure that they continue to be able to access the capital markets.

The market gets this. Before the crisis every covered bond was issued at a spread over the government bond of the country that it was from. Very suddenly though it occurred to the market that this was not justified and it became the norm for covered bonds to price inside governments, frequently more than 1% inside. Indeed it has now become one of the more reliable ways of defining ‘peripheral’ countries – those countries where the government is no longer the best borrower in the country.

I suspect that as we start to see more corporate bonds from the CEE region, often from corporates with deeply conservative financial ratios, the CEE credit market might take heed of the lessons from the covered bond market and start to price inside govvies. With all due respect to sovereign debt offices out there I not only suspect it, I also hope it.

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