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How COVID-19 Will Change Covered Bonds


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How COVID-19 Will Change Covered Bonds


While fiscal and monetary responses to the COVID-19 pandemic have headed off a liquidity crisis, they may have weakened credit quality by increasing overall indebtedness. In this report, S&P Global Ratings analyzes how the pandemic and the policy response to fight it will affect the covered bond market. In our opinion, residential mortgage market performance should generally be better than in recent crises due to support measures for workers and the expected limited correction in house prices. Certain segments of the commercial real estate market could be hit harder, such as retail and lodging, but cover pools' exposure to them tends to be limited. We expect COVID-19 related rating downgrades of covered bond programs in 2020 to be limited by credit protection features of covered bonds, and by the outlook on banks and sovereigns.

Still, downside risks prevail and uncertainties are high, as the pandemic might last longer and spread more widely than envisaged, with knock-on effects for the credit quality of the underlying collateral, issuing banks, and sovereigns. Central bank facilities are dampening investor-placed issuance, and encouraging retained issuance. This could last longer than generally expected and diminish investors' interest in the product. Covered bonds could support the recovery by funding assets other than mortgages, but regulation and European Central Bank (ECB) treatment will be key.

Unprecedented Fiscal And Monetary Measures Avoid A Liquidity Crisis

Strict lockdown measures enacted since March have been broadly successful at controlling the spread of the coronavirus in Europe, and the number of new cases of COVID-19 have now fallen to less than 10% of the early April peak.

So far, fiscal and monetary authorities have effectively managed the immediate problems raised by the crisis with a number of extraordinary and sweeping measures. Large injections of liquidity by the ECB with its now €1.35 trillion Pandemic Emergency Purchase Program (PEPP), an extension of its other asset purchases, and more favorable terms for banks' refinancing operations, have prevented financial markets from sizing up and kept credit flowing to the real economy.

The EU has also contributed its own emergency measures: a €540 billion, three-layer safety net, providing another source of low cost funding for governments' own emergency fiscal stimulus and for small and midsize enterprises (SMEs).

Chart 1


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But Transition To The New Normal After COVID-19 Is Likely To Be Bumpy

We expect eurozone GDP to contract by 7.8% this year and rebound by 5.5% next year. This would still leave the eurozone economy 2.6% smaller at the end of 2023 than in our pre-crisis baseline. We forecast U.K. GDP to contract by 8% this year, followed by only a 6.5% rebound in 2021.

The current public health emergency is the biggest risk to economic growth, in our view. Another surge in COVID-19 cases followed by renewed lockdowns in Europe or its largest trading partners would hurt the economy. Similarly, an abrupt withdrawal of extraordinary fiscal support or too little stimulus to finance the recovery could lead to a sharp rise in bankruptcies and unemployment and a slower return to growth (see "Credit Conditions Europe: Curve Flattens, Recovery Unlocks," published on June 30, 2020, and "Eurozone Economy: The Balancing Act To Recovery," published on June 25, 2020).

Table 1

Our European GDP Forecasts 2019-2023
GDP growth (%)
2018 2019 2020f 2021f 2022f 2023f
Germany 1.5 0.6 -6.2 4.4 2.6 1.6
France 1.8 1.5 -9.5 6.8 3.1 2.4
Italy 0.7 0.3 -9.5 5.3 2.3 1.6
Spain 2.4 2 -9.8 6.8 3.8 2.3
Eurozone 1.9 1.2 -7.8 5.5 2.9 2
Denmark 2.4 2.2 -5.4 3.2 1.6 1.6
Norway 1.3 1.2 -6.2 3.9 2.6 2.4
Sweden 2.2 1.2 -6.4 4.8 2.9 2.4
U.K. 1.3 1.4 -8.1 6.5 2.6 2.1
f--forecast. Source: S&P Global Ratings.

Short-Time Work Schemes Avoided A Sharp Rise In Unemployment, But Temporary Workers Are Less Likely To Benefit

The unprecedented use of short-time work schemes in the eurozone's largest economies has so far prevented a surge in unemployment, which was 7.3% in April 2020, only up by 0.1 percentage point from February. Despite these measures, we still expect unemployment to rise to 8.8% in 2020.

However, compared with permanent workers, freelance and temporary workers are much less likely to benefit from short-time work. Moreover, they are at greater risk of losing their jobs in a downturn as hiring and firing costs tend to be lower for workers in temporary jobs (see: "European Short-Time Work Schemes Pave The Way For A Smoother Recovery," published on May 20, 2020.)

A limited increase in unemployment should support the performance of mortgage cover pools, but significant exposure to borrowers on temporary contracts or to self-employed borrowers may signal pockets of risk.

Chart 3


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Payment Holidays Offer Short-Term Relief But Credit Concerns Loom

Governments and banks in various countries have supported households and small business customers affected by the coronavirus, with measures including the suspension of scheduled mortgage payments.

We have investigated the rates of borrowers' payment holiday utilization. Our estimates consider a variety of sources, including discussions with servicers, originators, investor reports, and other publicly available sources.

Incentives and disincentives of use, together with ease of accessing schemes, vary across countries, and in our opinion, they are the main factor behind the different payment holiday utilization rates. Although the underlying borrowers' credit quality is partly driving payment holiday utilization, it seems secondary to operational considerations. We therefore expect that increased unemployment, rather than current payment holiday utilization, will be the main catalyst of future performance.

In general, we understand that loans in payment holidays will be treated by the program administrators as eligible for various asset performance tests. The exceptions tend to be in jurisdictions lacking government-sponsored initiatives, such as the Netherlands.

Chart 5


Swift Central Bank Action Limits The Deterioration In Credit Conditions For Housing Markets

Credit conditions for house purchases have tightened in Europe, but only moderately so, thanks to the substantial and timely response of the ECB and national central banks, and more broadly because of government support to the household sector. Conditions should gradually improve again in line with the economic recovery that we expect to start in the third quarter of this year. More generally, we expect monetary policy to remain extremely loose across Europe for several years, translating into ongoing low mortgage rates and underpinning the housing market during the recovery.

Chart 6


Chart 7


Government Job Support Will Contain European Housing Market Price Falls

An outright collapse in European house prices is unlikely, because governments across Europe were swift to deploy support packages in response to the economic crisis. This will contain the decline in house prices, in our view.

However, we think some countries will be harder hit than others. Where the pandemic has wreaked more damage, or where government support to households is less generous, job and income losses will be greater, and house prices will fall further. Conversely, prices are likely to fall less in markets where housing supply is short, or where institutional investors play a more significant role (see "Government Job Support Will Stem European Housing Market Price Falls," published on May 15, 2020).

Chart 8


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Commercial Mortgages Will Take A Hit But Cover Pools' Exposure Is Limited

We forecast a greater negative credit impact from COVID-19 on commercial real estate (CRE) assets than residential real estate assets. First, CRE prices have outpaced residential prices in recent years. Second, secular trends such as the rise of working from home and growth of e-commerce, have clouded the outlook for the sector, which may negatively affect CRE performance long after the crisis is over. Retail and lodging are more at risk, while it is still early to assess the long-term impact on offices.

Chart 10


We believe the existing pressures from online sellers on bricks-and-mortar retailers will continue and will be exacerbated by the COVID-19 pandemic. By the end of 2019, there was a general expectation that shopping center values would fall by about 5% in 2020. This has now increased to about 25%. That said, the supply-demand mismatch in retail real estate is much more significant in the U.K. and in the U.S. than it is in continental Europe.

Even before COVID-19, many key European office markets were undersupplied, manifested in low vacancy rates and increasing rents. GDP declines and increasing unemployment are typically associated with higher vacancy rates, declining rents, and falling property values. However, because of long leases, these developments do not normally happen overnight, but take months if not years to show.

The COVID-19 blow may make some office tenants reduce their footprint to save costs but it may also encourage employers to use more space, to give their employees more room per person.

While we believe that CRE asset performance may deteriorate, we do not anticipate this significantly impairing the credit quality of the covered bonds that we rate, due to the limited exposure to sectors that we consider to be more at risk.

Chart 11


Available Overcollateralization Should Cushion Collateral Performance Deterioration

Our current base case scenario is that the deterioration in collateral performance will not impair the overall credit quality of the covered bonds that we rate. We expect a limited negative impact on prime residential mortgage loans, with key risks in countries where we foresee greater unemployment, such as in Spain and the U.K., and in pools with significant exposure to self-employed borrowers or borrowers on temporary contracts. We expect a more severe effect on the performance of CRE assets, but they generally constitute a relatively small part of the cover pools backing covered bond programs that we rate.

Moreover, the available credit enhancement is on average almost six times the overcollateralization required for the current ratings, and therefore sufficient to absorb a greater increase in losses than we currently expect.

In most instances, this additional collateral is maintained to give banks the flexibility to issue additional notes at short notice, for example for jumbo retained issuances, as we observed earlier this year. However, it is not likely that such increased issuance will lead to significantly reduced available credit enhancement that could require a review of our ratings. That said, we continue to expect any potential changes in sovereign or issuer credit ratings (ICRs) to be the most likely trigger for changes to our covered bond ratings.

Chart 12


The Outlook On Banks Has Turned Negative But The Number Of Downgrades Has Been Limited So Far

The COVID-19 outbreak has resulted in a rapid shift in our ratings outlook bias for European banks, with 46% now carrying negative outlooks compared to 14% at end-2019. The number of bank downgrades has been modest so far: most banks started with comfortable capital and liquidity buffers, the economic shock is expected to be shorter than a standard recession, and unprecedented government support for households and companies should help contain the damage. Still, weaker asset quality and revenue pressure will exacerbate many banks' pre-existing profitability challenges (see "How COVID-19 Is Affecting Bank Ratings: June 2020 Update," published on June 10, 2020).

Chart 13


Chart 14


Sovereign Rating Affirmations Reflect Monetary Flexibility And Economic Resilience

Despite our projection that average eurozone government debt will increase by just under 15 percentage points of GDP this year, we have recently affirmed our ratings on Austria, Spain, Belgium, Germany, France, Greece, Italy, and Portugal. This is because, in our view, monetary flexibility and economic resilience play a larger role in a country's ability and willingness to service debt than a single year's fiscal outcome. While debt to GDP is rising, debt-servicing costs continue to decline, benefiting eurozone creditworthiness.

The fundamental question for sovereign ratings in advanced economies remains what the long-term effects of the pandemic will be on their productive capacity. We still believe that eurozone debt profiles will benefit from long maturities, and the ECB's highly supportive monetary stance (see "The Seven Key Questions We Ask About Eurozone Government Debt Profiles," published on May 21, 2020).

Chart 15


Unused Notches Partially Mitigate Bank Downgrade Risk

Rating actions on the issuing bank or on the sovereign explain most of our covered bond rating actions over the last 10 years. Since the COVID-19 pandemic began, we have reflected changes to the issuer's outlook in outlook changes on seven covered bond programs that we rate. Most covered bond programs that we rate still have stable outlooks (see "Global Covered Bond Insights Q2 2020," published on June 30, 2020).

The presence of unused notches of ratings uplift reduces the risk of covered bond downgrades if we were to lower our rating on the issuing bank. Unused notches are the number of notches the ICR can be lowered by, without resulting in a downgrade of the covered bonds, all else being equal.

Given our current sovereign ratings, covered bond ratings in most jurisdictions would not change due to a one-notch downgrade of the sovereign, with some exceptions. We would expect mortgage programs in Ireland, Greece, Italy, and Spain, as well as programs backed by public sector assets in Belgium, France, and the U.K., to be most sensitive to changes in the respective sovereign ratings.

Chart 16


Retained Issuance Will Likely Play A Larger Role For Longer

Investor-placed covered bond issuance will probably be lower in 2020 than in 2019, due to lower mortgage origination volumes, volatile market conditions and revamped central bank funding facilities. However, overall issuance could be higher than in previous years, because of a surge in retained issuance, given the need to create high quality collateral for repo operations.

On the monetary policy side, the very large output gap that is forming means the ECB may need to keep stimulating demand at least until 2023. Therefore, we expect retained issuance to play a larger role beyond 2020. At the same time, other looming pressures—such as compliance with leverage ratios and output floors—could encourage investor-placed issuance, especially once monetary and fiscal intervention wanes (see "Asset Quality Not ECB Liquidity Will Determine Eurozone Banks' Fates," published on July 2, 2020).

Chart 17


Covered Bonds Could Help Support Economic Recovery And The EU's Environmental And Social Objectives

The COVID-19 backdrop is accelerating the debate on fiscal solidarity in the EU, which is responding swiftly and forcefully with a three-layer €540 billion safety net and a proposed €750 billion recovery plan.

For the first time, the EU intends to use its strong credit signature to absorb an asymmetric yet common shock on the member states and foster its environmental and social objectives, including 1) the twin transition toward a green and digital Europe, 2) reforms and increased competitiveness of member states, and 3) investment in strategic technologies (see "The EU’s Recovery Plan Is The Next Generation Of Fiscal Solidarity," published on June 8, 2020).

Covered bonds could play a key role in pursuing these objectives, achieving sustainability goals (via so-called green and social covered bonds), facilitating investments by the local and regional governments (via public sector covered bonds), and supporting the recovery of the SME sector (via so-called European Secured Notes).

Table 2

Next Generation EU: Breakdown By Budget Commitments (Bil. €)
1. Single market, innovation, and digital 69.8
of which InvestEU Fund 30.3
2. Cohesion and values 610
of which recovery and resilience facility 560
of which grants 310
of which loans 250
3. Natural resources and environment 45
of which common agricultural policy 15
of which just transition fund 15
4. Resilience security and defense 9.7
of which health program 7.7
5. Neighborhood and the world 15.5
Total 750

Sustainable Issuance Is Set To Grow

In the past few years the issuance of environmental and social themed covered bonds has steadily risen. Green covered bonds remain the main sustainable covered bond type with energy-efficient and green real estate financings accounting for approximately 75% of recent sustainable issuance. However, in the last couple of years there have been several issuances of a new type: the "social" covered bond.

Residential and commercial mortgages may support green bonds where the loans are for properties that are either built or refurbished to certain green standards, or social bonds where loans are for affordable housing. Additionally, public sector financing may lend itself to social bonds given the role of the public sector in supporting local communities and achieving societal benefits, thereby allowing a series of initiatives by local and regional governments (LRGs) to be developed. For example, social covered bonds could help finance loans to public hospitals.

We believe that policy measures announced to support the recovery will support sustainable covered bond issuance. That said, key factors for the success of these covered bonds will be their regulatory treatment, for example, in terms of capital and liquidity ratios, and the ECB's treatment as part of its collateralized funding facilities.

Chart 18


Soaring Local And Regional Borrowing Could Revamp Public Sector Covered Bonds' Issuance In Certain Jurisdictions

By the turn of the century, covered bonds were mainly backed by public sector loans, but since then, mortgage-backed programs have gained more market share. This was due to the reduced supply of assets eligible for German public sector covered bond programs following the withdrawal of public sector guarantees from state-owned banks (Landesbanks), and that debt issued by saving banks is no longer eligible.

We assume that a continuing global recession will further increase the funding needs of local and regional governments in 2020-2021 (see "COVID-19: Fiscal Response Will Lift Local And Regional Government Borrowing To Record High," published on June 9, 2020). In addition, credit guaranteed by the regional governments, local authorities, public sector entities, multilateral development banks, or international organizations is typically cover pool eligible. Among countries that have used public sector covered bonds in the past, we forecast the greater increase in LRGs borrowing in Germany, Spain, and Italy. While we assume that in Spain and Italy the central government or related entities will cover most of the LRGs' funding needs, public sector covered bond issuance in Germany may increase.

Chart 19


Chart 20


European Secured Notes Could Help Alleviate Funding Constraints In Certain Jurisdictions

European Secured Notes (ESNs) are a proposed new type of bonds that would fund SME and infrastructure loans using covered bond techniques. While ESNs were not part of the European Directive on covered bond harmonization, the crisis hit the SME sector particularly hard and European authorities may consider relaunching ESNs (see "Understanding The Role Of European Secured Notes In Funding SME And Infrastructure Lending," published on May 21, 2019 and "Harmonization Accomplished: A New European Covered Bond Framework," published on April 18, 2019).

ESNs could alleviate funding constraints for SME sectors and create eligible collateral for repo facilities. In order to be successful, the regulatory treatment should be defined, and clarify: 1) the definition of high quality SME loans, 2) the exception from bail-in and from clearing of derivatives, 3) the treatment under the Undertakings for the Collective Investment in Transferable Securities (UCITS) directive, the Capital Requirements Regulation (CRR), Solvency II, and liquidity coverage ratio (LCR), and 4) eligibility and haircut in the ECB's collateral framework.

While this instrument won't be available to support the initial phase of the recovery, it may play a significant role in certain countries, such as Italy and Spain, in the medium term.

Chart 21


S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the COVID-19 pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our macroeconomic and credit updates here: As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Antonio Farina, Madrid (34) 91-788-7226;
Marta Escutia, Madrid + 34 91 788 7225;
Secondary Contact:David Benkemoun, Frankfurt + 49 69 3399 9162;
Analytical Manager:Barbara Florian, Milan (39) 02-72111-265;

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