The unprecedented policy response to the COVID-19 pandemic depressed covered bond issuance but supported underlying asset performance. Some of these policies will be unwound once the economic recovery gathers pace, others will remain for longer, but most will have long-term consequences for the covered bond market.

Monetary Policy Intervention Will Depress Issuance Until 2023

The policy response to the pandemic caused a collapse in covered bond supply. Investor-placed issuance in the first six months of 2021 was less than half that of the same period in 2019 (see chart 1). This is because issuers have limited need for new wholesale funding given the availability of ultra-cheap central bank facilities, and customer deposits surged during the pandemic.

Chart 1

Generous fiscal support measures, along with lockdowns that limited households' opportunities to spend, contributed to an increase in savings. Eurozone household savings rates as a percentage of disposable income almost doubled to an unprecedented 24.6% in summer 2020, from a long-term average of 12.8%. We estimate that European households accumulated excess savings of about 12 percentage points of disposable income (€300 billion or 2.7 percentage points of GDP) last year, compared with the trend that would have prevailed without the pandemic. And these reserves are likely to have increased further in the first quarter of 2021 (see "Economic Outlook Europe Q3 2021: The Grand Reopening," published June 24, 2021, on RatingsDirect.)

Moreover, eurozone banks have taken almost €1.5 trillion of additional ECB funding since the terms of its long-term refinancing operations were eased in 2020. Countries in which covered bond issuance decreased the most--for example France and Spain--are also among those with the strongest take-up by the banking system under this facility (see chart 2).

Chart 2

We don't expect issuance to return to pre-crisis levels before 2023 at the earliest, although volumes should tentatively pick up from their current low levels once social-distancing measures are relaxed and the economy rebounds in the second half of the year. We expect the savings rate to return to its pre-pandemic level by the end of 2021, and households to spend at least part of the excess savings they accumulated during lockdowns. An improving economic outlook will also support asset formation: we expect bank lending to expand by between 2% and 3% in 2021. When mortgage lending outpaces customer deposit growth, lenders typically access wholesale funding markets and can use mortgage loans as collateral for issuing covered bonds. Moreover, banks won't want to be absent from the market for too long, as this would compromise their relationship with investors. Still, continued access to cheap central bank funding will slow the rebound in issuance volumes.

Inflation developments appear to be key to the issuance outlook. Low inflation could cause central banks to maintain a looser monetary policy for longer; higher-than-expected inflation could force monetary authorities to curb quantitative easing and might encourage banks to issue more wholesale funding in order to lock in the current low interest rates. Eurozone inflation has spiked since the start of the year due to one-off factors, and energy prices have recently driven inflation close to the ECB's target of 2% (see chart 3 and "How Long Can The ECB Yield Shield Last?" June 11, 2021.) However, we expect the momentum to abate through to the end of 2021, before a slide-back to 1.4% in 2022, as pressure on wages will remain low and oil prices will likely stabilize. Low inflation will probably allow the ECB to keep stimulating demand for at least the next few years, preventing a return to normal covered bond issuance volumes before 2023.

Chart 3

Expect The Emergence Of A More Diverse, Sustainable Market

What will be the shape of the asset class once the economic recovery is well established and central banks withdraw monetary support? Issuance growth will likely remain subdued in traditional markets given only modest demand for mortgage assets and limited funding needs. Volumes already declined by 9% in the eurozone in the decade before the COVID-19 crisis, while increasing globally by 13%.

This points to the first source of growth: new markets. Outstanding covered bonds increased by almost five times over the past decade outside established markets, such as in Central and Eastern Europe and Asia-Pacific (see chart 4).

Chart 4

The transposition of the EU harmonization directive should support further covered bond issuance in Central and Eastern Europe, by either aligning existing local frameworks to international best practices or by introducing new dedicated legislation (see "Harmonization Accomplished: A New European Covered Bond Framework," April 18, 2019.) Outside the EU, we can expect additional issuance from new markets, such as Japan and Brazil. Housing demand should also grow substantially over the coming decades in emerging Asia and Latin America, and covered bonds could become an important instrument for mobilizing private capital toward mortgage financing in these regions (see chart 5 and "Covered Bonds In New Markets: Expect Only A Gradual Recovery," March 8, 2021.)

Chart 5

The second source of growth should be sustainable issuance, namely green and social covered bonds. Sustainable covered bonds constituted less than 5% of overall issuance in 2019, growing to more than 14% in the first half of this year (see chart 6). Sustainable issuance still poses considerable challenges for issuers, including the dearth of eligible cover pool assets, considerable upfront costs, and limited pricing differentials compared with vanilla issuance (see "Sustainable Covered Bonds: Assessing The Impact Of COVID-19," Dec. 1, 2020.) However, it benefits from insatiable investor demand and a supportive regulatory environment. The EU has recently approved or amended several regulations, including the benchmark regulation, the regulation on sustainability-related disclosures in the financial services sector, and the taxonomy regulation for climate change. These initiatives have begun to provide greater clarity for market participants, allowing issuers to plan the necessary investments required to set up a green or social covered bond issuance program. The taxonomy regulation and its delegated acts are particularly significant for covered bond issuers, as they establish the list of activities considered environmentally sustainable. In April the European Commission approved the climate delegated act, which defines the technical screening criteria for climate change mitigation and climate change adaptation. The criteria for real estate have been relaxed since the first draft proposal was released at the end of 2020: for example for the acquisition or ownership of buildings built before Dec. 31, 2020, the buildings will need either an Energy Performance Certificate of class A, or be within the top 15% of the national or regional building stock. The addition of the latter condition is a positive development for the covered bond industry, as it will expand the pool of available assets. While many issuers already align their green covered bond frameworks with International Capital Market Association (ICMA) green bond principles, we expect that alignment with the taxonomy will become a more relevant factor once these technical screening criteria become applicable in January 2022.

Chart 6

Economic Rebound Will Limit Collateral Deterioration

Collateral performance has been remarkably stable since the onset of the pandemic, with residential mortgage arrears generally steady or decreasing. Alongside central banks' intervention that stabilized financial markets, a forceful and swift fiscal and regulatory response supported the real economy and prevented far worse economic outcomes. Short-time work schemes in the eurozone's largest economies have so far prevented an unemployment surge, and mortgage payment deferral schemes have prevented borrowers from falling into arrears (see chart 7).

Chart 7

We expect only a limited credit impact on prime residential mortgage loans once this fiscal and regulatory support wanes. First, payment moratoria have already expired in several European countries, without a meaningful hike in delinquencies. Second, there is still no evidence of any cliff effects in the labor market from the phasing out of short-time work schemes, and only about 2% of the eurozone's active population was using such schemes during the third wave of lockdowns (see charts 8 and 9). Third, Europe's house prices should still grow in the second half of 2021 and in 2022, albeit more slowly than in 2020 (see "Europe’s Housing Market Will Chill In 2021 As Pent-Up Pandemic Demand Eases," Feb. 22, 2021). Fourth, the support will be withdrawn against a background of a strong economic rebound: we forecast that the eurozone economy will grow by 4.4% in 2021 and 4.5% in 2022. A robust economy should prevent a significant labor market deterioration, which is historically correlated with an increase in nonperforming assets. We expect eurozone unemployment to peak at 8.2% in 2021-- well below the 13.0% reached in 2013 after the sovereign debt crisis. Similarly, we expect nonperforming assets to increase throughout 2022 but to remain well below the levels experienced a decade ago.

Chart 8

Chart 9

We predict a greater negative impact on commercial real estate assets than residential real estate assets. First, commercial real estate prices outpaced residential prices before the pandemic. Second, secular trends, such as the rise of working from home and growth of e-commerce, may negatively affect asset performance long after the public health crisis is over. We believe the existing pressure from online sellers on bricks-and-mortar retailers will continue, and shopping center values could fall further. That said, the supply-demand mismatch in retail real estate is much more significant in the U.K. than it is in continental Europe. The Association of German Pfandbrief Banks (VDP) estimates that prices of retail properties in the country were down by just 2% at the end of 2020 year on year, and rents under new contracts declined by 1.4%. Conversely, U.K. shopping center values fell by approximately 25% over the same period, predominantly due to declining rents. Even before COVID-19, many key European office markets were undersupplied, manifested in low vacancy rates and increasing rents, and ever-declining yields. 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 VDP estimates that prices for office properties in Germany actually increased by 1.7% in 2020. 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 commercial real estate asset performance may deteriorate, we do not anticipate this significantly impairing the credit quality of the covered bonds that we rate, due to the availability of credit enhancement to absorb losses and the limited exposure to sectors that we consider to be more at risk (see chart 10).

Chart 10

Overcollateralization And Structural Features Will Soften Pressure On Ratings

We have not downgraded any of the covered bond programs that we rate since the beginning of the COVID-19 crisis. We revised outlooks to negative on less than 15% of them, and upgraded four of them, due to rating actions on the issuing banks or the related sovereigns.

Our outlook for the sector remains stable, even though we expect mortgage arrears to peak in Europe only in 2022.

The credit enhancement available to most of the programs that we rate significantly exceeds the level required to maintain the current ratings. And we have not recorded any material deterioration in available credit enhancement, even when issuers used their programs extensively for retained issuance.

Chart 11

Historically, rating actions on the issuing bank have been the single biggest explanation for rating actions on covered bonds. Currently, rated programs benefit on average from 2.4 unused notches--the number of notches the issuer rating can be lowered without resulting in a downgrade of the covered bonds (see "Global Covered Bond Insights Q2 2021," June 30, 2021.) The presence of these unused notches of ratings uplift reduces the risk of covered bond downgrades even if there are limited downgrades of issuing banks. 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 12

Throughout their 250-year history, covered bonds have weathered the ebb and flow of financial markets by adapting and innovating. While the post-COVID recovery poses unique challenges for this asset class, covered bonds will likely remain resilient, as they have the potential to adapt and remain an essential funding tool for financial institutions--in Europe and beyond.

Related Research

• Global Covered Bond Insights Q2 2021, June 30, 2021
• Economic Outlook Europe Q3 2021: The Grand Reopening, June 24, 2021
• How Long Can The ECB Yield Shield Last?, June 11, 2021
• Covered Bonds In New Markets: Expect Only A Gradual Recovery, March 8, 2021
• Europe’s Housing Market Will Chill In 2021 As Pent-Up Pandemic Demand Eases, Feb. 22, 2021
• Sustainable Covered Bonds: Assessing The Impact Of COVID-19, Dec. 1, 2020
• Covered Bonds 2021 Outlook: Policy Intervention Is Reshaping The Role Of Covered Bonds, Nov. 25, 2020
• How COVID-19 Will Change Covered Bonds, July 8, 2020
• Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019