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Credit FAQ: How We Rate Japanese Covered Bonds

Credit FAQ: How We Rate Japanese Covered Bonds

S&P Global Ratings has received several questions about its analytical approach to rating Japanese covered bonds. This Credit FAQ explains how we apply our criteria to rate them. (For further details see "Covered Bond Ratings Framework: Methodology And Assumptions," published June 30, 2015, and "Covered Bonds Criteria," published Dec. 9, 2014.)

Frequently Asked Questions

What is the analytical process for rating covered bonds?

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 operational and administrative risks--which mainly assesses whether a rating on the covered bond may be higher 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 jurisdictional and cover pool-specific factors; and
  • Combine the above results and incorporate any additional factors, such as counterparty risk and country risk, to determine the final covered bond rating.

Chart 1

Can S&P Global Ratings rate covered bonds without a dedicated legal framework?

Yes, if certain legal requirements are met.   Covered bond issuance is possible according to a dedicated legal framework, "legislation-enabled" covered bonds, or through contractual means, "structured" covered bonds (see also "S&P Global Ratings' Covered Bonds Primer," published on June 20, 2019). The assessment of legal and regulatory risks focuses primarily on the degree to which a covered bond program isolates the cover pool assets from the bankruptcy or insolvency risk of the covered bond issuer. We expect a covered bond program to meet certain minimum legal provisions to be eligible to be rated above the issuer credit rating (ICR) on the issuing bank. To the extent that these risks are effectively mitigated, we can assign a rating to a structured covered bond program even though there is no dedicated legal framework in Japan, which enables covered bonds to be treated differently from other senior debt in a bank resolution scenario.

Legal requirements typically include the following characteristics:

  • The cover pool assets are available in full to meet the obligations under the covered bonds.
  • There is no acceleration of interest and principal payments to covered bondholders if the issuer becomes insolvent.
  • The covered bonds are not exposed to a payment moratorium or forced restructuring applicable to other bank obligations.
  • The issuer's insolvent estate does not have a claim on cover pool assets that exceeds minimum regulatory or contractual overcollateralization.
  • External support mechanisms, such as derivatives or liquidity facilities, are not terminated if the issuer becomes insolvent.
  • There are appropriate provisions for cover pool management, particularly after the issuer's insolvency.
What is the starting point for the rating analysis?

The ICR on the issuer is the starting point for our analysis.  Due to the dual-recourse nature of the product, the rating on the covered bond is typically no lower than the rating on the covered bond issuer. Our covered bond analysis assesses the "reference rating level" (RRL), which reflects the probability of the issuing bank to continue servicing its covered bonds even following a default on its senior unsecured obligations. We may assign an RRL that is up to two notches higher than the ICR in jurisdictions that are subject to an effective resolution regime which explicitly exempts covered bonds from bail-in. Currently it is not clear how the Japanese Financial Services Agency (FSA) will treat covered bonds in a post-issuer insolvency scenario. Therefore, we would not assign additional notches of uplift according to the resolution regime analysis due to the uncertainty of its treatment and we would equalize the RRL to the ICR on the issuing bank.

What is the jurisdictional support assessment for Japanese covered bonds?

We assess the jurisdictional support as moderate, which allows for one notch of ratings uplift above the RRL.  If the issuer defaults and is not restored as a going concern following a bank resolution, we assume that a structured covered bond would then be solely backed by its cover pool. In our jurisdictional support analysis, we assess the likelihood that a covered bond program facing stress would receive liquidity support from a government-sponsored initiative instead of from the liquidation of collateral assets in the open market. To assess this, we analyze: 1) The strength of the legal framework; 2) The systematic importance of the covered bonds in their jurisdiction; and 3)The credit capacity of the sovereign to support the covered bonds. In assessing systemic importance, we analyze a jurisdiction's willingness to support covered bonds. Systemic importance refers to whether, in our view, covered bonds will play a significant role in an economy and financial system.

The jurisdiction-supported rating level (JRL) is our assessment of the creditworthiness of a covered bond program once we have considered jurisdictional support, but before giving benefit to a covered bond's ability to access other refinancing sources.

Our moderate jurisdictional support assessment means we would assign a JRL one notch above the RRL and ICR.

We based this assessment of the jurisdictional support on a number of considerations, including:

  • There is a strong legal framework in place that supports the asset isolation in favor of covered bondholders, and contractual provisions that can replicate the main characteristics that we typically expect to see in a legislation-enabled program.
  • Local lenders are already using collateralized lending, such as residential mortgage-backed securities (RMBS), and they have now started adding covered bonds to their funding mix.
  • Outstanding mortgage loans are around ¥200 trillion, of which only 15%-20% is currently used as collateral for RMBS, leaving ample capacity for covered bond issuance.
  • Japanese banks have considerable assets denominated in foreign currencies and covered bonds could constitute a competitive source of funding for these assets.
  • From a risk and regulatory perspective, covered bond issuance can reduce the duration mismatch between the assets and liabilities.
  • The experience of other countries shows that outstanding covered bonds can grow quickly once the market has been established.
  • The current rating on Japan and the fact that the sovereign has sufficient financial resources to support covered bonds, whose use is not subject to authorization or restrictions by supranational entities.
What is the maximum ratings uplift due to collateral support?

We can assign up to four notches of collateral-based uplift to covered bonds exposed to refinancing risks, unlimited to covered bonds where refinancing risk is structurally mitigated.  Our analysis of collateral support considers the extent to which additional levels of collateral increases the creditworthiness of the covered bond above what we have assessed through our jurisdictional support analysis. To assess the credit quality of the pledged assets in a cover pool, we generally use the securitization criteria for the type of assets pledged to the covered bond. We would analyze a pool of Japanese mortgage assets by applying our "Methodology And Assumptions For Rating Japanese RMBS," published on Dec. 19, 2014.

In programs exposed to refinancing risk, such as hard or soft bullet structures, we could assign a potential collateral-based uplift of up to four notches above the issuer's JRL. This is because we believe that the cover pool administrator of a Japanese covered bond program could liquidate the assets if the issuer becomes insolvent, due to the depth of the Japanese capital markets and the presence of a thriving RMBS market (see chart). We would also consider whether the overcollateralization is committed or voluntary, and whether liquidity is available for managing refinancing risk. The uncommitted overcollateralization and/or lack of committed liquidity may reduce the collateral-based uplift.

Refinancing risk is mitigated in conditional pass-through (CPT) covered bonds, where the maturity of the bonds can be extended to match the maturity of the assets if the issuer is insolvent. This maturity extension prevents the forced liquidation of assets and allows us to delink the rating from the issuer and the potential collateral-based uplift is unlimited.

Chart 2


Does sovereign risk constrain the rating on Japanese residential mortgage covered bonds?

Only to the extent that refinancing risk is not covered for at least 12 months.  Our structured finance ratings above the sovereign criteria (RAS criteria) set a maximum rating 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 (see "Incorporating Sovereign Risk In Rating Structured Finance Securities: Methodology And Assumptions," published on Jan. 30, 2019). Where refinancing needs are not covered for at least a 12-month period and the covered bonds are issued in a country that is not a member of a monetary union, these criteria would allow a maximum of two notches of potential ratings uplift above the long-term sovereign foreign currency rating, irrespective of the underlying assets' sensitivity to country risk. Given Japan's current long-term unsolicited sovereign credit rating of 'A+', the maximum potential rating on the bonds would be 'AA'. Structural mechanisms to cover refinancing needs over a 12-month period can include liquidity reserves, in which upcoming maturity payments are pre-funded, or extendible maturities. Where refinancing risk is covered for at least 12 months, the maximum potential rating on Japanese mortgage covered bonds would be 'AAA'.

Chart 3


In the instance where a program has outstanding foreign-currency-denominated covered bonds, the ratings on the covered bonds may be constrained by our T&C risk assessment. Our T&C assessment reflects our view of the likelihood of a sovereign restricting access to foreign exchange needed to satisfy a securitization's debt service obligations. Unless there are structural mitigants for T&C risk 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, which in this case would be 'AA+'. To put it in another way, if there are such structural mitigants, we could assign the ratings on the covered bonds up to 'AAA' regardless of the country's T&C assessment.

Related Criteria

  • Incorporating 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
  • Methodology And Assumptions For Rating Japanese RMBS, Dec. 19, 2014

Related Research

  • Global Covered Bond Characteristics And Rating Summary, published quarterly
  • Global Covered Bond Insights, published quarterly
  • S&P Global Ratings' Covered Bonds Primer, June 20, 2019
  • New Covered Bond Markets Set To Expand Amid Legislative And Market Developments, March 21, 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.

Primary Credit Analysts:Hiroshi Sonoda, Tokyo (81) 3-4550-8474;
Marta Escutia, Madrid + 34 91 788 7225;
Secondary Contacts:Yuji Hashimoto, Tokyo (81) 3-4550-8275;
Antonio Farina, Madrid (34) 91-788-7226;

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