In its Covered Bond Market Insights reports, S&P Global Ratings provides an overview of the local covered bond market, explains how the relevant legal framework and domestic mortgage market work, and compares key characteristics of the existing programs. In this report, we present the Spanish covered bond market.

Overview: New Economic Playground And Legislative Framework

The Spanish covered bond market is one of the largest globally, with more than €204 billion outstanding bonds at the end of May 2023. The first covered bond law was introduced in 1981 to regulate mortgage covered bonds. Another legislation was introduced in 2002 for public sector covered bonds. Both laws were recently superseded by the Spanish Royal Decree Law that came into force in July 2022 to align the Spanish covered bond framework with the EU harmonization directive.

The Spanish covered bond market includes mortgage-backed covered bonds ("cédulas hipotecarias"), public sector debt-backed covered bonds ("cédulas territoriales"), and multicédulas (repackage of cédulas hipotecarias).

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The European Central Bank scales back quantitative easing

Aiming to reduce inflation to its 2% medium-term target, in June 2022, the European Central Bank began a series of interest rate hikes. This was followed by the scale back of its bond purchase programs and the recalibration of its targeted long-term refinancing operations.

The rapid increase in interest rates tightened financing conditions and intensified broader mortgage credit risks, particularly in countries like Spain where most mortgages are tied to variable rates. House price prospects also weakened, and we forecast slight adjustments during 2023 and 2024.

Despite Spanish banks repaying borrowings from the central bank, we expect their net issuances will be limited, given modest business growth and rising funding costs. Even if so, we expect covered bond debt to pick up compared with other capital instruments, given most Spanish banks have already met the minimum requirement for own funds and eligible liabilities.

Harmonization reshapes the Spanish covered bond legal framework

Spain's adoption of the European covered bond directive led to significant structural changes to the existing covered bond legislation. Among the key highlights, the framework now allows for cover pool asset segregation, covered bond maturity extensions, and liquidity risk hedges. We view these amendments as positive, as they introduce greater transparency and align Spanish legislation to EU standards.

After the implementation of the Royal Decree Laws, the credit quality of collateral backing the Spanish mortgage covered bonds we rate improved. Additionally, while there was also a material decrease in the programs' available credit enhancement, these were still maintained at levels sufficient to support our covered bond ratings. The Spanish government proposed, in March 2023, further amendments to the new covered bond framework. Although Congress approved these changes, they were pending approval from the Senate when the country's early general election was announced. As such, the timing and process of implementing the amendments may now be affected.

Covered bonds rating outlooks are stable, despite challenges ahead

Despite fiscal policy tightening, we believe Spanish banks' credit performance will prove resilient. This comes on the back of light operating structures and a significant boost in earnings that can absorb asset quality problems and rising costs (see "Spanish Banks In 2023: Navigating Rough Seas Again," published Jan. 18, 2023). We revised our outlook on Spain to stable from negative in March 2022. This reduces the risk that a negative rating action on the sovereign could lead to downgrades on our rated covered bond programs (see "Spain Outlook Revised To Stable From Negative On Balanced Growth; 'A/A-1' Ratings Affirmed," published March 18, 2022).

However, increased interest rates and the decline in house prices may put pressure on portfolios' credit performance and the overcollateralization (OC) needed to maintain the ratings. We performed a scenario analysis to assess the impact of a further two percentage point increase in interest rates and a material decline in house prices. The results showed the ratings on Spanish mortgage covered bonds would not be affected.

The Legal Framework: An Overview

Published in November 2021 and partially amended in June 2022, Royal Decree Law 24/2021 aligns the Spanish covered bond framework with the EU harmonization directive. It has been in force since July 2022, and governs all new and already outstanding covered bonds. The Royal Decree Law defines the cover pool as a specific pool of assets that guarantee payment obligations linked to a covered bond program, and that are registered and segregated from other assets on the issuer's balance sheet. This differs significantly from the previous framework where covered bonds were backed by the issuer's entire nonsecuritized mortgage or public sector loan book, which benefited from substantially higher levels of credit enhancement than the Royal Decree Law requires.

The new framework also introduced:

• Stricter eligibility criteria, including loan-to-value (LTV) ratio limits, for mortgage loans to be included in the cover pool register.
• The appointment of a cover pool monitor.
• A 180-day liquidity provision.
• The possibility to issue covered bonds with extendible maturities.
• Derivatives to hedge risks associated with the program.

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On March 31, 2023, the Spanish government proposed further amendments to Royal Decree Law 24/2021. The amendments would allow issuers to actively manage the available OC (subject to pre-approval from the cover pool monitor), clarify that the administrator's right to accelerate covered bonds upon issuer insolvency applies only if the value of cover pool assets is less than the value of the covered bonds, and allow property valuation reassessments to be performed using house price indexes. These changes are yet to be fully approved, and the timing and process may now be affected by the anticipated general election in July 2023. As they currently stand, the Royal Decree Laws continue to support our view of a very strong legal covered bond framework in Spain (see "Spanish Covered Bonds: Harmonization Achieved Through Royal Decree Law," published July 13, 2022).

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Currently, most issued covered bonds are subject to hard bullet maturities and the programs make no use of derivatives to hedge interest rate or foreign exchange risk. These features may change, given the new law introduces the ability to issue covered bonds with maturity extensions, to include substitute assets in the cover pool to limit liquidity risk, and to use derivatives to hedge risks associated with the program. Furthermore, issuers have greater flexibility to naturally hedge mismatches between assets and covered bonds, given they can now select the segregated assets that will be included in the cover pool register.

The Spanish Mortgage Market: An Overview

Temporary economic slowdown while inflation is controlled

We forecast Spain's economic growth will decelerate to 1.1% in 2023 from 5.5% in 2022, pick up to 1.6% in 2024, and to above 2% in 2025. We expect the Spanish unemployment rate to slightly increase in 2023 and 2024 and improve again in 2025 (see "Spain," published March 20, 2023, and "Banking Industry Country Risk Assessment: Spain," published April 14, 2023).

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Spanish house prices will fall in 2023 and 2024

Weaker economic growth and higher interest rates will also weigh on house prices. We forecast Spanish house prices will decline by 2.5% in 2023 and 1.0% in 2024, followed by a 1.5% increase in 2025 (see "European Housing Prices: A Sticky, Gradual Decline," published Jan. 11, 2023).

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The Spanish mortgage market should stay resilient

Sticky inflation may force monetary authorities to raise rates further, which may lead to asset performance deterioration. Mortgage borrowers will see disposable income squeezed as monthly mortgage payments rise, particularly in a country like Spain--where most loans are tied to variable interest rates.

In our opinion, most mortgage borrowers will remain current under their payments, given that we expect the employment rate to remain fairly stable. Furthermore, since mid-2016 the popularity of fixed-rate mortgages rose rapidly, and borrowers refinanced to take advantage of historically low rates. At the same time, more seasoned floating-rate mortgages benefit from most being subject to the French amortization method, where the interest burden as a share of the installment is higher at the beginning of the contract.

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More generally, when compared to previous crises, Spanish households will face this economic slowdown with relatively higher savings and more manageable mortgage debt. The ratio of mortgage debt to deposits and cash in financial institutions dropped to 0.45 in December 2022 from about 0.82 in December 2007. Additionally, according to the Bank of Spain, the percentage of granted household loans with LTV ratios above 80% declined to 8.3% from about 13% over the same time period.

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We also believe that the projected house price decline will not substantially pressure Spanish mortgages. Furthermore, the real estate market does not show signs of significant imbalances in terms of affordability that could aggravate loan performance.

So far, residential mortgages' performance has been very stable, with nonperforming loan ratios on a downward trend.

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While Spanish mortgage covered bond bonds are primarily backed by residential mortgage loans, they also contain nonresidential assets, making up on average 11.01% of the collateral behind the programs that we rate as of March 2023.

Commercial assets vary significantly and can consist of office space, retail facilities, hotels, industrial space, agricultural properties, property developers, and land. The largest commercial segments are often industrial space and property developers. Offices (particularly nonprime), logistics, and lower yielding assets appear more exposed as yields adjust. But asset performance has also been broadly stable so far, and the pressure appears to be more on valuations and refinancing (see "Covered Bonds Could Ease The Pain In European Commercial Real Estate," May 16, 2023). Moreover, Spanish cover pools' exposure to these sectors is limited.

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Ratings Outlook: Stable On Bank And Sovereign Resiliency

Covered bonds' dual recourse nature, as well as the different layers of credit support available to them, has resulted in them having a relatively greater credit performance stability than financial institutions.

Spanish covered bonds are still, among the markets that we rate, relatively sensitive to the movements of issuer credit ratings, given the limited number of unused notches from which they benefit. We define unused notches as the number of notches the issuer rating can be lowered without resulting in a downgrade of the covered bonds.

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During 2022, we raised most Spanish issuer credit ratings by one notch and mostly maintained the stable outlooks, despite economic challenges ahead. The stable outlooks reflect that, while we believe asset quality problem loans will emerge, we expect the deterioration to be contained and only a moderate increase in credit costs. Furthermore, higher rates will positively affect banks' net interest income, given the largely floating balance sheets and a significant share of nonsensitive deposits.

The ratings on Spanish covered bonds are also dependent on the ratings on Spain. This is because, in most cases, a negative rating action on the sovereign would result in a similar rating action on covered bonds, all else being equal. Our unsolicited sovereign rating on Spain is 'A/Stable/A-1'. The stable outlook on the sovereign reflects that we anticipate the government will pursue policies that support growth and a degree of fiscal consolidation over the next four years, while the economy will benefit from incoming EU grants and loans equivalent to over 2.0% of GDP annually in inflows until 2027. Long-term economic growth prospects are sound, and the country's external accounts remain in surplus. The decision to bring national elections forward has no immediate implication for Spanish fiscal and economic policies, in our view (see "Early Elections In Spain To Take Place Against A Backdrop Of Economic Resilience But High Debt," published May 29, 2023).

The third key component in determining Spanish covered bond ratings is the quantity and quality of the segregated cover pool available to covered bond investors. Although Spanish legislation defines primary assets to be included in the cover pools as either public sector or mortgage loans, about 91% of the total outstanding covered bonds are backed by mortgages. The Spanish residential mortgage market is characterized by amortizing floating-rate mortgages with maturities of up to 30 years and LTV ratios averaging 70% at origination. Mortgages are typically lent on owner-occupied properties.

Over the past few years, borrowers in the Spanish residential mortgage market have gradually become more interested in fixed-rate loans to take advantage of very low interest rates. Between end-2015 and end-2022, the percentage of newly originated fixed for life rate mortgage loans increased to 65.5 from 10.3 according to the Bank of Spain. We also observed this pick up in the cover pools behind the Spanish programs we rate, with the percentage increasing to 34.4 from about 2.4.

Following the Royal Decree Laws implementation, Spanish cover pools' credit quality materially improved, as measured by our weighted-average foreclosure frequency (our measure of aggregate default rate) and weighted-average loss severity (our measure of aggregate loss-given default). The stricter eligibility criteria in terms of LTV ratios, exclusion of most loans in arrears, and relatively higher share of residential mortgages in the cover pool have largely contributed to the improvement in credit results. The share of commercial real estate mortgages in the cover pools decreased to 11% from 17% between December 2021 and December 2022.

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At the same time, Spanish issuers have materially decreased the levels of available OC, but maintained them at levels commensurate with the rating. Required OC for the ratings remained relatively stable despite the improved pool credit quality because other components in our analysis, such as asset-liability maturity mismatch, available excess spread, or interest rate mismatch also affected the results.

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We currently rate all Spanish covered bond programs either 'AA' or 'AA+', with stable outlooks (except Cajamar, which has a positive outlook). They all benefit from up to one unused notch of uplift above the issuer credit rating.

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Chart 13 shows our average credit enhancement calculations across countries. Compared to the average, Spanish programs have relatively higher credit and market risk. This is mainly because we assess Spanish programs' credit quality relatively conservatively, given most Spanish issuers only provide stratified cover pool information rather than loan-by-loan data, which is provided in other jurisdictions. Furthermore, the majority of Spanish covered bonds currently feature hard bullet maturities.

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Environmental, social, and governance considerations

Environmental and social credit factors are typically neutral in our analysis of Spanish mortgage covered bonds.

We view governance factors as a negative consideration in our credit rating analysis where there is no commitment to maintain a minimum level of OC, because this introduces the risk that the available credit enhancement could decrease to levels not commensurate with the current rating. This factor reduces the achievable ratings or the number of unused notches available to covered bond programs. Furthermore, Spanish issuers generally provide stratified cover pool information, which introduces higher uncertainty compared to loan-by-loan information and results in higher level of required credit enhancement (see "ESG Credit Indicator Report Card: Covered Bonds," April 7, 2022).

Scenario Analysis: Overcollateralization Levels To Withstand Key Challenges

Higher interest rates can negatively affect our collateral analysis. They can increase the credit enhancement required to maintain the ratings on programs exposed to unhedged interest rate mismatches. They can also reduce bank lending and the credit enhancement available for the cover pool. Finally, they can increase the probability of borrowers defaulting on their mortgage loans, especially if they are paying a floating interest rate. Similarly, corrections in house prices may lead to higher LTV ratios on mortgages, potentially affecting outstanding borrowers' repayment capacity and the loans' eligibility to be included as collateral in the cover pool.

We conducted a scenario analysis where we tested the impact of a further two percentage point increase in interest rates for the Spanish covered bond programs we rate. The impact was generally positive, with an average decrease of 1.3% in the OC required for the ratings. The impact was relatively more beneficial in programs with a higher share of floating-rate assets than floating-rate liabilities, as these benefit from comparably higher levels of excess spread under this scenario. This analysis does not take into consideration the impact of the higher refinancing costs banks will face when repaying maturing notes. But this will be partially mitigated by the assets added to the pool probably paying a higher interest rate.

We also carried out a scenario analysis with large drops in residential house prices to gauge how these would affect OC commensurate with the current ratings. We tested the effect of house price drops of 20% and 35%, similar to what we observed in Spain during the financial crisis between 2008-2013 and completely different from our current, limited projected house price corrections. While testing the impact of these scenarios on the credit risk observed in the cover pools that we rate, we removed our additional adjustment reflecting current overvaluation in the Spanish housing market.

Chart 14 shows the effect of the different scenarios on the OC commensurate with the current ratings on the programs compared to their available credit enhancement level. Despite Spanish issuers materially decreasing the level of available OC following the implementation of the Royal Decree Laws, the current levels are still sufficient to withstand the stressed correction in house prices and support the ratings.

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Related Criteria

• Global Framework For Payment Structure And Cash Flow Analysis Of Structured Finance Securities, Dec. 22, 2020
• Incorporating Sovereign Risk In Rating Structured Finance Securities: Methodology And Assumptions, Jan. 30, 2019
• 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
• Covered Bonds Criteria, Dec. 9, 2014
• Principles Of Credit Ratings, Feb. 16, 2011

Related Research

• Bulletin: Early Elections In Spain To Take Place Against A Backdrop Of Economic Resilience But High Debt, May 29, 2023
• Covered Bonds Could Ease The Pain In European Commercial Real Estate, May 16, 2023
• Banking Industry Country Risk Assessment: Spain, April 14, 2023
• Global Covered Bond Insights Q2 2023: The Implications Of Rising Interest Rates, April 12, 2023
• Spain, March 20, 2023
• Spanish Banks In 2023: Navigating Rough Seas Again, Jan. 18, 2023
• European Housing Prices: A Sticky, Gradual Decline, Jan. 11, 2023
• Spanish Covered Bonds: Harmonization Achieved Through Royal Decree Law, July 13, 2022
• ESG Credit Indicator Report Card: Covered Bonds, April 7, 2022