S&P warns on 'misleading' covered bond risk

LONDON: Covered bonds are not the homogenous asset-class as some perceive it to be, S&P warned on Tuesday. In a report entitled 'Never Underestimate Credit Risk In Mortgage Covered Bonds', the agency said that the common view that mortgage covered bonds were homogenous and universally low risk was misleading.

S&P analysts added that characteristics of individual transactions were not only diverse but also liable to change over time due to variations in credit enhancement, asset-liability mismatches and collateral performance.

"The mortgage covered bond programs that we rate from Canada, France, and the U.S. are backed by pools solely comprised of residential mortgage loans from a single country," S&P analysts wrote. "However, this is not always the case. Some other programs' cover pools include combinations of mortgage loans, public sector assets, and substitute assets."

S&P said that this particularly applied to German programs where commercial mortgage loans dominated some of the cover pools. This trend was also evident in Spanish mortgage cover pool, and to a lesser extent some Danish and Swedish programmes, S&P added.

S&P says asset-liability mismatch, which determines the level of credit enhancement, is the most important risk for covered bonds, followed by credit risk associated with the underlying mortgage cover pools.

This credit risk becomes increasingly important as the asset-liability mismatch declines, and in these instances "it is even more crucial to understand how the pool's credit characteristics interact and affect the creditworthiness of the covered bonds," S&P said.

However, these cover pools differ between issuers and so have are a major influence investors' actions.

A full understanding of these risks is required, but investors' task can be complicated by full details not always being made available, the agency notes.

To counter this, S&P has called recently called for "greater transparency on covered bond programs and their associated risk".