In its Covered Bond Market Insights report, S&P Global Ratings presents the local covered bond market, explains how the relevant legal framework works, provides an overview on the local mortgage market, and compares key characteristics of the existing programs. In this report, we review the Swedish covered bond market.

Overview: Sweden, A Nordic Benchmark

Sweden remains one of the five-largest covered bond markets, together with Denmark, Germany, France, and Spain, with outstanding issuance totaling Swedish krona (SEK) 2.50 trillion (or €231 billion) as of August 2022, slightly lower than a year prior. Public euro-denominated benchmark covered bond issuance from Sweden is already above the levels of 2020 and 2021, with €4.3 billion issued so far in 2022 (see chart 1).

The Swedish covered bond market is relatively new but continues a long tradition of mortgage bonds funding property purchases in the country. Until the mid-2000s, specialized Swedish mortgage institutions issued unsecured mortgage bonds. Because mortgage banks had limited business scope, the mortgage bonds were regarded as covered by mortgages, even if not directly linked to mortgage collateral by law. Once implemented in 2004, covered bond regulation converted existing mortgage bonds to covered bonds. Covered bonds now make up approximately 46% of all debt issued by Swedish financial institutions.

Chart 1

Chart 2

Covered Bond Issuance May Slow Down For The Rest Of The Year

In parallel with other European jurisdictions, 2022 year-to-date Swedish investor-placed benchmark covered bond issuance has been relatively strong, almost twice the 2021 full year volume as access to cheap central bank funding begins to diminish. In the second half of 2022, we expect issuance to slow down, similar to that of other European jurisdictions. This is due to rising interest rates and continued high household deposits following the pandemic, which lower funding needs (see chart 3).

First issuances under the new framework following the implementation of the European covered bond harmonization directive may lead to initial higher than expected issuance in the second half of 2022 but we still expect issuers to be reluctant given the current low needs for funding.

Chart 3

Implementation of the EU's Covered Bond Directive

On June 14, 2022, the Swedish government published a final amended law to align the covered bond law with the EU's harmonization directive. The main amendments relate to loan-to-value (LTV) requirements, overcollateralization, the introduction of 180 days' liquidity coverage, and clarification of rules for extensions.

The extension rules are permitted to avoid the issuer's default, but will not be available for an insolvency administrator. We understand that the extensions will also be considered for the regulatory 180 days' liquidity coverage requirement, which will only apply to bonds issued after July 8, 2022. We understand most Swedish covered bond issuers should enter into resolution before the insolvency of the issuer. In our view, further clarification could help market participants understand when maturity extensions can occur.

Transition rules allow issuers to continue to tap existing series up to a defined limit (see "European Covered Bonds Reach Harmonization Milestone As The Journey Continues," published on July 12, 2022).

We do not expect the proposal to affect our current ratings on Swedish covered bond programs. For now, the introduction of additional coverage of 180 days' liquidity is unlikely to cover our consideration of 180 days' liquidity risk as grandfathered covered bonds remain exempt from the requirement.

The Swedish Housing Market Cools As Interest Rates And Inflation Rise

The strong price momentum in major European housing markets is likely to cool over the next few years owing to declining affordability, rising interest rates, and high inflation. However, strong household balance sheets accumulated during the COVID-19-related lockdowns, as well as an influx of refugees from Ukraine, should sustain housing demand and continued, but slower, price growth (see "European Housing Markets: Soft Landing Ahead," published on July 13, 2022).

In Sweden, house prices continued their sustained rise of over 12% in Q1 2022 (Q1 year-on-year estimate), one of the largest increases in Europe. However, since the peak in February 2022, house prices have decreased in recent months, following declining affordability based on the Swedish price-to-income ratio.

Chart 4

We expect that several factors contributing to rising housing prices will reverse in the coming years. We expect mortgage rates to rise going forward--in September 2022, the average mortgage rate with a maturity of three years was above 3.5%, which is 2 percentage points higher than it was in January of the same year. Moreover, the sharp increase in house price, driven by households' changed preferences for larger living space during the pandemic, could reverse as restrictions are lifted. The increasingly high mortgage rates and weaker development in disposable income, together with rising construction costs will contribute to the slow-down in household demand for housing. At the same time, many new apartments have been built in recent years, which has increased supply (chart 5). The Swedish Central Bank (Riksbank) forecasts that housing prices will continue falling during the coming year. However, it forecasts that housing prices at the end of 2024 will still be higher than before the pandemic.

Chart 5

Despite the continually increasing household debt that the Swedish Financial Supervisory Authority's (SFSA's) measures, aimed at faster amortization and lower LTV mortgages, could help lower public debt gradually strengthening household balance sheets. However, the progress in reducing household indebtedness has still not led to significantly lower debt. This is partly due to the amortization requirement only applying to new mortgages, a temporary relaxation of amortization requirements during the pandemic, and the comparably long maturities of Swedish mortgage loans. In our view, the reinstatement of amortization requirements will eventually help house price stability and strengthen household balance sheets.

Monetary Policies Against High Inflation

The eurozone economy's focus has shifted away from COVID-19 toward the inflationary environment and rising interest rates. The imbalances between demand and supply, reinforced by Russia's invasion of Ukraine and new pandemic-related restrictions in China, have pushed up prices for energy, various input goods, and food (see "Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce," published on June 27, 2022).

In Sweden, in line with global trends, high inflation is affecting households and is undermining purchasing power. Inflation has risen much more than expected by the Riksbank following the initial increases to the policy rate in April 2022, to 0.75% from 0.25% and to 1.75% recently--the latest increase is the largest since the autumn of 1992. The aim is to stop inflation expectations from causing a wage-price spiral in upcoming salary negotiations. The Riksbank expects interest rates to increase further over the next six months. Rising interest rates will further cause house prices to fall, in our opinion.

Furthermore, in the second half of 2022, the Riksbank intends to decrease its purchases under its asset purchase program by 75% compared to the first six months. The Riksbank's assessment is that its holdings of securities, including covered bonds, should decrease during 2022. With this monetary policy, the Riksbank hopes for inflation to fall back in 2023 and be close to 2% from 2024.

Sweden's Covered Bond Framework

Swedish covered bonds are issued on the basis of the Swedish covered Bonds Issuance Act ("Lag 2003:1223 om utgivning av sakerstallda obligationer") and complementary regulation. The Act came into force in 2004 and was recently amended by SFS 222:803 to align to the EU directive.

All issuing institutions must have a specific license to issue covered bonds to ensure that the covered bonds are part of the individual banks' long-term business model. Most Swedish mortgage assets are originated, and covered bonds issued, by separate mortgage bank entities, like Swedbank Hypotek AB, Stadshypotek AB, Nordea Hypotek AB, The Swedish Covered Bond Corp. (SCBC), and Länsförsäkringar Hypotek AB (LF Hypotek), for example. However, covered bonds can also be issued directly from a bank's balance sheet, as is the case with SEB AB and Landshypotek Bank AB. For those covered bonds issued directly from the balance sheet, legislation protects and segregates the cover pool post issuer insolvency.

In addition to general banking supervision, a bank issuing covered bonds is subject to a special form of supervision by the SFSA to ensure compliance with the covered bond law. The SFSA appoints an independent cover pool inspector to ensure that the register for the cover pool is properly maintained and to ensure compliance with the law's matching and market risk limits at all times. Derivatives must be entered in the cover registers, and payments to counterparties rank equal to covered bond creditors.

The limits set by Swedish law on LTV ratios for loans in the cover pool decide the eligible loan part, which benefits covered bond investors. Should the market value of the properties that secure the loans decline, LTV ratios above the regulatory limits will be ineligible for the cover pool. Since the amendment, LTV ratio limits in Sweden have slightly increased to reflect limits set out in the capital requirements regulation. Commercial real estate remains limited to 10% of the cover pool and overcollateralization remains at a minimum nominal 2%.

The issuer must ensure that the cover pool contains a liquidity buffer that covers the highest daily accumulated net liquidity outflow regarding the covered bonds for the next 180 days. Covered bond with extensions may consider the extended maturity date in the liquidity calculation.

Chart 6

Table 1

A key feature of the Swedish domestic SEK-denominated covered bond market is the tap issuance format, which allows issuers to frequently access the market in smaller issuance sizes. The tap market helps issuers match assets and liabilities without having to rely on infrequent, and potentially uncertain, benchmark issuance in the international covered bond markets.

Euro benchmark issuance remains an alternative and provides Swedish issuers with longer-term funding opportunities compared with the domestic SEK market. Euro-denominated funding also provides investor diversification, although its attractiveness depends on the cost of required swaps. As a result, the level of euro-denominated issuance has fluctuated over time and reflects the euro/SEK interest differential.

Amortization Requirements Reintroduced

Due to the spread of the coronavirus and its effects on the Swedish economy, on April 14, 2020, Finansinspektionen (SFSA) gave banks the possibility of granting temporary exemption from amortization requirements to all new and existing mortgagors. Around 12% of Sweden's mortgagors used the exemption. However, as the economy recovered in 2021, SFSA no longer considers households to have a need for an amortization exemption, which expired on Aug. 31, 2021.

Due to the amortization requirement only being applicable to new mortgages and the exemption during the pandemic, we have so far not observed significant changes to weighted-average maturities of mortgage loans in the cover pool.

Chart 7

We expect the ongoing focus on formal amortization requirements will be positive for asset and liability mismatch management in Swedish covered bonds, and will reduce the volume of interest-only loans. Since the second half of 2021, the share of interest-only mortgages has decreased to below the pre-pandemic level likely due to the reintroduction of the amortization requirements, which we believe helps stabilize Swedish house prices.

Chart 8

Table 2

Mortgage Market Overview: Indirect Effects From The Russia–Ukraine Conflict On The Swedish Economy

We estimate that the Swedish economy will grow by 1.8% in 2022, down from 5.1% in 2021. Record levels of household wealth and a strong labor market supporting consumption, together with business investments, will be a key growth driver. However, the indirect effects from the Russia-Ukraine conflict such as reduced purchasing power due to increasing inflation, weaker global demand, and supply chain disruptions will likely slow economic growth. At the same time, we believe pandemic-related risks are low given the high vaccination rate and low fatality risk, alongside the economy's greater resilience to temporary restrictions. Our real GDP growth forecast of about 2% for 2023-2025 is more in line with historical rates.

Unemployment reached 8.8% in 2021 and remains above the eurozone average of 8.3%. We estimate the unemployment rate will decrease to 7.9% in 2022 and then down to about 7.0% in 2025.

Table 3

Chart 9

Chart 10

In 2021, house prices increased over 11%--one of the largest increases among European countries--which contributed to an increase in household debt. However, the high inflation, normalization of housing demand as pandemic effects subside, rising interest rate, and reinstatement of macroprudential policies should dampen house price growth. That said, although the share of loans with fixed rates has increased in recent years, about 50% of fixed rate mortgages are fixed at less than a year. Together with high household indebtedness of about 200% disposable income, this makes households sensitive to interest rate changes.

Features Of Swedish Covered Bond Programs

While relatively homogeneous, the Swedish covered bond market comprises covered bonds backed by a mix of assets: residential, commercial, multifamily, agriculture mortgage loans, and public sector debt. A cover pool can include different types of assets, but the law limits the percentage of strictly commercial assets to 10% of the collateral pool. Generally low interest rates have made it challenging for issuers to use covered bonds to refinance public debt, and so it makes up a small fraction of cover pools.

Approximately 98% of outstanding covered bonds--Säkerställda obligationer (SOs)--issuance is backed by a mix of two types of collateral: residential mortgage-backed (including tenant-owner rights) and commercial mortgage-backed covered bonds. Swedish regulators consider multifamily properties as residential collateral, while we analyze their credit risk by applying our commercial real estate criteria (see "Related Criteria").

Residential mortgage loans:   Most Swedish residential mortgage loans are secured by single-family homes and have a variable interest rate fixed for less than a year; borrowers are protected as for other consumer loans. The level of amortization depends on borrowers' LTV ratio, and multiple loan parts per borrower are common, where one part could be repayment and the other interest only. The mortgages backing Swedish covered bonds often include a portion of residential mortgage loans paying interest only until their contractual maturity date, which may be the next interest reset date (three months) or 40 years. In our analysis of credit risk in Swedish covered bonds, we consider that the issuing bank has defaulted and that the cover pool administrator is winding down the pool's assets to meet payments on the covered bonds. We understand that the administrator has a legal right to request full amortization on the loan at market conditions, after the default of the issuing bank. We expect the maturity for an amortization post issuer default to be in line with the maximum offered in the market.

Historically, mortgage loans have much shorter observed maturity dates due to Sweden's high prepayment rates secured by the consumer protection act. In line with our covered bonds criteria, we consider the constant prepayment rates (CPR), an input in our asset-liability mismatch analysis, at 5% for mortgage loans in Sweden. We will continue to monitor the market and adjust CPR levels considering market trends.

Bostadsrat:  Historically, the preferred form of ownership of apartments in Sweden has been "Bostadsrat" (tenant-owner right). Supply has grown significantly compared with the only other alternative--rental apartments. Bostadsrat are mainly found in the larger Swedish cities, but the ownership format is found throughout Sweden. Buyers obtain a "right to live" in an apartment as part of a cooperative housing association. In addition to own mortgage payments, the borrower has an obligation to pay a monthly service fee to the association, which helps maintain the association and pay off the first ranking mortgage loan to the association. Since tenant-owner-right borrowers often have a second-ranking right and can be liable for additional payments (for example, if other owners do not pay), we consider these loans may have higher foreclosure frequencies depending on loan seasoning. In 2022, the share of loans secured by tenant-owner rights in our rated programs remains stable versus previous years (see chart 11).

Chart 11

Commercial real estate loans:   Commercial properties eligible for Swedish cover pools vary but mainly comprise office space, retail facilities, and to a lesser extent, industrial space. However, the largest segment is often housing associations and multifamily housing, which from a regulatory standpoint is not considered commercial real estate exposure. The loans are normally variable-rate linked to the Swedish interbank offered rate (STIBOR) and have shorter maturities and interest-only characteristics.

Public sector loans:   Public sector loans are relatively diverse, ranging from loans to Swedish LRGs, public utility companies, export credit agencies, and supranationals. However, the market share of local and regional government funding has decreased, because banks have struggled to find assets with attractive margins for covered bond funding. Funding cost for the public sector remains very low, but the funding demand may increase on the back of the pandemic.

Green covered bonds and ESG considerations  A potential new source for issuance growth is green and social covered bonds. Landshypotek helped pave the way for green covered bonds, while the SCBC has since followed suit. This is in part due to the perceived advantageous funding conditions for green and social covered bonds but, more importantly, issuers state that there's interest from investors who normally do not invest in the covered bond market. However, the Swedish green and social covered bond market remains limited in size, as issuers focus on issuance of unsecured green bonds with a higher greenium. Based on the growing local ESG investor interest, we believe Swedish covered bond issuers could soon be at the forefront of developments within this expanding segment.

Environmental and social credit factors are typically credit neutral in our analysis of Swedish mortgage covered bonds. Certain features of the Swedish tax system and market have incentivized the origination of a relatively high proportion of interest-only loans, which we consider as credit negative in our analysis. However, the share of this type of loans declined since 2016, with the introduction of mandatory amortization requirements.

In terms of governance, although the Swedish covered bond framework requires issuers to maintain liquid assets to cover at least six months of liquidity needs, the requirement does not apply to grandfathered covered bonds. This leads to a reduction of the achievable ratings or the number of unused notches available in all our rated programs due to the lack of liquidity coverage.

We consider governance factors as being relatively less supportive in Swedish programs where there is no commitment to maintain a minimum level of overcollateralization. This introduces the risk that the available credit enhancement could decrease in the future to levels that are not commensurate with the current rating, and it reduces the achievable ratings or the number of unused notches available to the covered bond program.

Comparison Of Swedish Covered Bond Programs

Due to the relatively high level of perceived property overvaluation in Sweden, the credit risk of the residential component of Swedish cover pools is slightly higher than credit risk in cover pools in strictly residential-based jurisdictions with more stable house prices. However, the very low mortgage LTV ratios in Sweden reduce expected losses when defaults occur, which compares positively with other jurisdictions with higher LTV ratios.

In 2022, the indexed weighted-average LTV ratio in our rated programs has slightly decreased thanks to the Swedish house-price increase. The credit coverage (foreclosure frequency and loss severity) has improved mainly due to the seasoning improvement and the decrease in current LTV ratios, which is partially offset by an increase in the share of jumbo valuations in most of the programs.

Table 4

Chart 12

Rating Outlook: Bonds Are Well Insulated From The Risk Of Bank Downgrades

Most Swedish covered bond issuers have very high issuer credit ratings (ICRs; see chart 13). These allow all rated issuers to reach the 'AAA' rating for their covered bonds based on jurisdictional support alone. The programs benefit from different numbers of unused notches. These are notches by which the ICR can be lowered, without resulting in any effect on the covered bond program's jurisdiction-supported rating level (JRL), all else being equal.

Chart 13

Table 5

Swedish programs on average have slightly lower credit risk compared with peer countries, but higher market risk, reflecting asset liability mismatch. The available credit enhancement is slightly lower relative to other peer countries (chart 14).

Chart 14

Scenario Analysis: Swedish Covered Bonds Ratings Can Withstand House-Price Corrections

We have carried out scenario analysis with large drops in house prices to gauge whether these would affect the overcollateralization that is commensurate with our rating. In our current credit model, we consider that the Swedish house price reflects an overvaluation of 32.2%. We have tested this scenario analysis for house-price drops of 40% and 50%, which is more severe than the largest historical house price drop in the early 1990s where single-family house prices decreased by 20% from their 1989 peak.

The overcollateralization in line with our current rating does not increase significantly in the most stressful scenario (see table 6). These hypothetical price drops do not affect the achievable rating on any of the programs either.

Table 6

Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
• Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015
• Methodology And Assumptions: Analyzing European Commercial Real Estate Collateral In European Covered Bonds, March 31, 2015
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Global Covered Bond Insights Q3 2022, Sept. 8, 2022
• Covered Bonds Outlook Midyear 2022: The Meaning Of Higher Interest Rates, July 18, 2022
• European Housing Markets: Soft Landing Ahead, July 13, 2022
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Sovereign Risk Indicators. July 11, 2022
• French Covered Bond Market Insights 2022, June 30, 2022
• Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce, June 27, 2022
• Cost Of Living Crisis: Mapping Exposures In European RMBS And Covered Bond Markets, June 27, 2022
• Sweden, May 2, 2022
• ESG Credit Indicator Report Card: Covered Bonds, April 7, 2022
• Swedish Covered Bonds: Harmonization Plan Paves Way For Further Rating Uplift, Feb. 4, 2021
• Glossary Of Covered Bond Terms, April 27, 2018
• New Swedish Mortgage Amortization Law Will Likely Benefit Swedish Covered Bonds By Reducing Asset-Liability Mismatch, June 3, 2016

Related Transaction Updates

• Transaction Update: Danske Hypotek AB (Mortgage Covered Bond Program), Aug. 19, 2021
• Transaction Update: Swedbank Mortgage AB Covered Bond Program, March 17, 2020
• Transaction Update: Landshypotek Bank AB (Mortgage Covered Bonds), Dec. 3, 2021
• Transaction Update: Sparbanken Skane (Mortgage Covered Bond Program), Oct. 13, 2021
• Transaction Update: Lansforsakringar Hypotek (Mortgage Covered Bond Program), April 4, 2022