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, compares key characteristics of the existing programs, and presents the results of a scenario analysis.

German Covered Bond Market Maintains Momentum Amid Challenging Environment

2022 was a record year for German benchmark covered bond issuances, totaling €44 billion. In 2023 euro benchmark issuance has remained resilient with €31 billion issued by the beginning of September. Germany is the second largest market for covered bond issuance so far in 2023. But clouds are gathering, with loan growth significantly decelerating. Furthermore, most targeted longer-term refinancing operations (TLTRO) drawdowns have been repaid, limiting the need for further covered bonds to replace European Central Bank (ECB) funding.

As of year-end 2022, the outstanding volume of covered bonds exceeded the previous year's volume for the second consecutive year. We believe total investor placed issuance in 2023 will near the record levels reached in 2022, and that 2024 will be another strong year. In a "higher for longer" interest rate environment, issuers will continue to favor covered bonds over other, more expensive, sources of wholesale funding. Germany remains the second-largest covered bond market after Denmark and the largest euro benchmark market, with outstanding volume totaling €393.6 billion as of end-2022.

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The ECB remains hawkish in light of high inflation

Although inflation has peaked and has decreased in recent months, the ECB remains hawkish and raised interest rates by another 25 points to 4.25% on July 27, 2023. In addition, the ECB ceased reinvestments under its asset purchase program (APP)--including CBPP3--but will continue those under the pandemic emergency purchase program (PEPP) until the end of 2024.

We forecast eurozone inflation will remain around 6% this year and 2.7% in 2024. That means we do not expect the ECB to achieve its price stability target before 2025.

Rising interest rates cause increasing difference between lending and funding rates

The unprecedented velocity of the rise in interest rates represents a challenge for Pfandbrief banks, in our view. The main task is matching the cover pool interest revenues (asset side) with the increasing cost of covered bond funding (liability side) to ensure covered bonds' attractiveness in a higher for longer interest rate environment. This may be particularly challenging for German residential mortgages with comparably longer fixed interest periods, although seasoned cover pools could soften the impact. Higher interest rates can negatively affect our collateral analysis results for programs exposed to unhedged interest rate risks. On the variable loans/liability side of the German mortgage covered bonds we rate we conducted a scenario test whereby we tested a three percentage point interest rate increase. This led to a lower required credit enhancement because Germany is mainly a fixed rate covered bond market, hence the volume of variable assets exceeds the limited variable liabilities, leading to a positive impact when interest rates are higher.

Chart 3

Asset liability mismatch increases, but does not affect overcollateralization required for rating

The inverted interest rates curve has driven covered bond issuance into shorter maturities. These can increase refinancing risk when they widen a program's asset-liability maturity mismatch (ALMM). Therefore, we conducted a scenario test by decreasing the current liability profile of our rated German mortgage covered bonds by one year. The average hypothetical increase of the target credit enhancement (TCE) is about 1.4 percentage points, and the maximum is 2.2 percentage points. While the impact is material for most of the programs we tested, the available credit enhancement continues to well exceed what's required for our current ratings. Furthermore, most of our mortgage programs need to cover 'AAA' credit risk to arrive at their respective rating, hence increased TCE has no impact on the rating and would only reduce the available unused notches.

Chart 4

New lending growth mainly backed by commercial properties

The Association of German Pfandbrief Banks(vdp) published that between April and June 2023 its member banks committed to new residential and commercial real estate (CRE) loans totaling €28.2 billion, a 38.2% year-on-year decline (€45.6 billion in second quarter 2022). However, compared with first quarter 2023 (€25.6 billion) new loan commitments increased by 10.2%. This increase is mainly supported by CRE loans, which increased by €4.1 billion compared to first quarter 2023, while residential loan commitments decreased by €1.5 billion in the same period.

An increase in the share of CRE loans in cover pools may increase our view of credit risk for the mortgage programs we rate. So far, the percentage of CRE assets overall has remained stable, but we observe that 50% of the top ten issuers have increased their exposure to CRE assets compared to last year and have reached the highest level over the observed period or are nearer to it (see chart 14A).

Chart 5

Unclear impact of new German real estate tax

The new German real estate tax--the tax property owners must pay municipalities yearly--comes into effect on Jan. 1, 2025. Real estate owners had until the end of January 2023 to provide details about their properties to the German tax authority. Since then, the tax authority has reevaluated nearly 36 million properties, with the outcome not yet fully clear. For some property owners the new real estate tax determination could be beneficial, while for others it could mean paying a much higher tax than before. In some cases, owners could pay 10 times more. As of March 2023, more than one million formal objections had reached the German tax authority, hinting that higher taxes are anticipated. Additionally, some municipalities have already increased their property collection rate (the factor municipalities apply to derive the final real estate tax) due to financial difficulties arising from the current inflationary environment, which could impose even higher payments on property owners. It may also lead to higher rental prices, if landlords pass on extra costs to lessees.

In our opinion, the new property tax's impact on the housing market remains too early to predict, mainly because it is only one factor of many to consider when purchasing a property. We expect clarity on the outcome of the change to take some time, with the Federal Ministry of Finance predicting that the majority of taxpayers' future real estate tax will remain uncertain until at least autumn 2024.

Bausparverträg: On the verge of a comeback?

Bausparverträge--savings used to build or buy a house--have a long tradition in Germany dating back to the 19th century. Their popularity increased rapidly from the late 1970s until the mid-1990s because they guaranteed high interest rates on savings and security. The loans remain very secure, but low interest rates have reduced demand for new contracts. In our opinion, recently rising interest rates could stop this decline. The 4%-5% annual fall in contracts observed in 2020-2022 has slowed down to 1.9% as of July 2023. According to the association of private building societies (Der Verband der privaten Bausparkassen, VDPB), demand is growing for Bausparverträge and €38 billion of contracts were arranged in the first half of 2023, 10% more than first half 2022.

Although the total number of outstanding contracts has declined, the volume saved under existing contracts has continued to rise. We expect older contracts with guaranteed higher interest rates to encourage owners to continue saving.

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N-bonds or NamensPfandbriefe, a German specialty

Since peaking in 2014 the traditionally smaller segment of the market--so-called "Namenspfandbriefe" (N-bonds)--has reduced as a percentage of the total market. An N-bond is a covered bond or debt security, which, unlike a typical Pfandbrief or security, is unregistered. No records are kept of the owner or transactions involving ownership. The liquidity of such bonds is generally considered lower than a typical Pfandbrief, and investors have traditionally been buy-to-hold investors, such as life insurance companies. They have also proven particularly popular for public sector funding. Rising interest rates might support issuance of N-bonds, since life insurance companies are again attracted to covered bonds after years of low returns. Concurrently, in the mortgage N-Bonds segment, the volume of outstanding bonds increased in June 2023 from end-2022, leading to a stable trend since overall mortgage covered bonds also increased (see chart 7).

Chart 7

Germany's Covered Bond Framework: A Strong Foundation

German covered bonds are issued based on the PfandBG. The PfandBG came into force in 2005 and has been amended several times. In May 2021 Germany's Bundesrat approved amendments to the PfandBG, implementing the EU's Covered Bonds Directive.

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Table 1

In addition to general banking supervision, covered bond issuers are subject to supervision by the Federal Financial Supervisory Authority (BaFin) to ensure compliance with the covered bond law. BaFin appoints an independent cover pool monitor to ensure the cover pool register is maintained at all times. Derivatives are eligible for inclusion in the cover pool under certain conditions and limitations. Payments to counterparties rank equal to payments due to covered bondholders.

One of the central pillars supporting the strong history of the mortgage Pfandbrief is that eligible loans may be included in cover pools only up to the mortgage lending limit of 60% of the valuation of the property securing the loan. Furthermore, the valuation is based on the mortgage lending value ("Beleihungswert"), a conservative valuation based on long-term considerations, and which by definition cannot exceed the current market price.

Overcollateralization, liquidity buffer, and maturity extension

Since July 8, 2022 the PfandBG has required a nominal statutory minimum overcollateralization of 2% for mortgage and public sector covered bonds and minimum 5% for ship and aircraft covered bonds. Potential winding-down costs after issuer insolvency are considered through the requirement to maintain a minimum overcollateralization coverage of 2% on a net present value (NPV) basis. Cover pool assets used for the NPV overcollateralization cannot be considered in the nominal overcollateralization calculation. We understand that the regulator has updated the definition of loan maturities in the calculation of 180 days liquidity needed.

Commingling risk

Commingling risk refers to the risk that cash collected from the cover assets (mortgage loans, for example) could be trapped in the insolvent estate or temporarily restricted from servicing the covered bonds. If the insolvent issuer's estate can make a claim, such cash collections may be considered lost or frozen depending on its status under general insolvency law. The German cover register does not constitute a legal entity before the default of the issuer. Therefore, following the issuer's insolvency, cash is held in the issuer's name and some cash holdings are held on the cover pool's behalf, which creates potential commingling risk. In the absence of structural mitigants we size for this risk in our overcollateralization calculation.

Table 2

Mortgage Market Overview: Higher Interest Rates And Persistent Inflation Take Their Toll

We revised our negative growth rate for 2023 and expect the German economy to shrink by -0.1% instead of the -0.3% previously expected. The economy is then expected to recover at a slightly higher rate of 0.8% in 2024. Beyond 2024, we expect growth rates of 1.6%-1.7%.

Though the unemployment rate remains at an all-time low, we expect it to rise marginally to 3.2% from 3.1% in both 2024 and 2025 and then to decrease to 3.0% in 2026.

Table 3

Chart 9

Property market outlook: Higher interest rates spell the end of house price growth

Recently rising interest rates have halted Germany's booming real estate market. We forecast residential house prices to fall by roughly 5% in nominal terms in 2023, and nearly 2% in 2024. Overall, we expect the peak-to-trough decline of German residential house prices to be around 12%. For 2025-2026 we expect moderate price increases of 1%-2%. Construction cost inflation seems likely to continue to fall rapidly, which typically would support construction activity in normal times, however, the declining house prices will likely limit its impetus. In fact, falling construction cost inflation might itself contribute to declining house prices, even if output remains constrained. This downward push might be particularly at play in Germany, where underlying demand for housing appears to be more robust than elsewhere, not least because of recent strong population growth resulting from a sizeable intake of refugees (see "European Housing Markets: Sustained Correction Ahead," published July 20, 2023).

The German mortgage market should stay resilient

Sticky inflation may force monetary authorities to raise rates further. However, this may not necessarily lead to asset performance deterioration. The main reason is that mortgage contracts mainly pay fixed interest for a period of up to 30 years, with most of those contracts fixed between 10 and 15 years. As shown in chart 10, the interest rate 15 years ago was even higher than today and was slightly lower than today 10 years ago. Hence, we do not expect borrowers who need to refinance their mortgage loans after their fixing period to experience a payment shock, since monthly interest rates will be at the same level or only slightly higher than before.

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Features Of German Covered Bond Programs

German cover bond legislation provides for dynamic cover pool management. This may affect the asset composition, the geographical focus of the assets, and the level of overcollateralization (as long as it is above the legal minimum), while issuers may utilize covered bonds more or less depending on their funding needs. Table 4 depicts the development of the top 10 issuers in Germany's covered bond market. It shows the evolution of outstanding bonds as the market has moved from covered bonds backed by public sector assets to mortgage assets. Moreover, the changes reflect consolidation in the market, with several mergers taking place since 2011.

Table 4

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Green Covered Bonds And ESG Considerations

Green and sustainable covered bonds have been popular with certain issuers in Germany, with €8.9 billion of issuance registered in 2022. At the beginning of September 2023, sustainable covered bond issuance had reached nearly €5 billion, lower than last year's total and lower as a percentage of total issuance. The lack of eligible assets, a limited greenium, and the challenges of implementing the EU Taxonomy have limited supply volumes. Nevertheless, we expect additional clarity on applicable regulations and strong investor demand to eventually support further growth.

In 2019 the vdp introduced minimum standards for green Pfandbriefe. Last year, it outlined minimum standards for the issuance of public green covered bonds. This is its third sustainability framework providing guidance to issuers and investors.

Environmental and social credit factors are typically credit neutral in our analysis of German mortgage covered bonds. In our assessment for public sector entities included in public sector cover pools we typically consider social factors to be a credit positive. Governance factors may reduce the number of unused notches, which provides protection if we downgrade an issuer.

Comparison Of German Covered Bond Programs

Given the changing utilization of covered bonds and the cover pools' risk composition, overcollateralization levels have fluctuated. Generally, available overcollateralization has been high, but chart 13 highlights notable differences in 2023, with average available overcollateralization increasing compared to last year. This is because some programs' covered bonds were redeemed, while the asset balance increased or reduced proportionally less than the redeemed covered bonds.

Chart 13

As chart 14B shows, most German covered bond issuers continue to include a higher share of German assets in their cover pools. But we also observe issuers with the lowest share of German collateral are now closer to their all-time low, or are below it. We perform our collateral support analysis using the respective criteria for the underlying asset type, while our resolution regime and jurisdictional support analysis reflects the issuer's jurisdiction.

Chart 14A shows the share of commercial assets varies significantly across issuers and remains broadly stable. On average, about 40% of the collateral is represented by commercial properties, slightly lower than last year (42%). According to the vdp, commercial mortgage activity has recently picked up, but this was not apparent in most German Pfandbrief issuers' cover pools as of second quarter 2023. In fact, the current share of commercial mortgages in nearly all programs is still lower than its highest level in the observed period. But we observe that 50% of the top ten issuers have increased their exposure to CRE assets compared to last year, reaching the highest level over the observed period or getting nearer to it. CRE assets continue to offer attractive margins for lenders and, specifically in Germany, issuers have taken advantage of available, longer-maturity funding options to lower refinancing risks. We believe covered bonds' longer funding profile may prove attractive to refinance CRE assets.

Chart 14A

Chart 14B

Table 5  |  View Expanded Table

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Ratings Outlook: Unused Notches Mitigate Bank Downgrade Risk

The German covered bonds which we rate are issued by highly-rated issuers, which are the first recourse for bondholders. These allow most of our rated issuers' covered bonds to reach the 'AAA' rating based on jurisdictional support alone.

As a result, the majority of our rated German covered bond programs benefit from multiple unused notches of ratings uplift, which protect the ratings on the covered bonds if the issuer is downgraded.

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Table 6

Chart 17 shows the breakdown of the average target credit enhancement levels of mortgage and public sector covered bond programs compared to the available credit enhancement across countries. We define the target credit enhancement as the overcollateralization commensurate with the maximum collateral-based uplift.

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Scenario Analysis: German Covered Bonds Can Withstand Substantial House-Price Corrections

In our last covered bond market insight report on Germany, we performed a scenario analysis in which we applied considerable drops in house prices (15% and 25% lower) and observed no rating impact (see "German Covered Bond Market Insights 2022," published on Oct. 17, 2022). Since we have yet to observe house price declines in the tested range, we have not updated the scenario analysis and still consider German covered bonds able to absorb such declines without a direct impact on our ratings.

Transaction Updates

• Deutsche Apotheker- und Aerztebank eG Mortgage Covered Bond Program, June 27, 2023
• Wuestenrot Bausparkasse AG (Mortgage Covered Bond Program), April 21, 2023
• DZ BANK AG Deutsche Zentral-Genossenschaftsbank, March 27, 2023
• DZ HYP AG (Mortgage Covered Bond Program), March 9, 2023
• DZ HYP AG (Public Sector Covered Bond Program), Feb. 27, 2023
• NRW.BANK Public Sector Covered Bond Program, Oct. 20, 2022

Related Criteria

• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• 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
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014

Related Research

• European Housing Markets: Sustained Correction Ahead, July 20, 2023
• Covered Bonds Outlook Midyear 2023: Rising Interest Rates Will Test Asset Performance, July 19, 2023
• Global Covered Bond Insights Q3 2023: Strong Issuance Is Here To Stay, June 29, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• German Covered Bond Market Insights 2022, Oct. 17, 2022
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Approach To Analyzing German Covered Bonds Clarified Following Changes To The German Covered Bond Law, Oct. 6, 2021
• Covered Bond Harmonization In The EU Remains A Work in Progress, July 13, 2021
• Commercial Real Estate In Covered Bonds: Is It Worth The Risk?, July 8, 2021
• ESG Industry Report Card: Covered Bonds, Nov. 9, 2020
• Glossary Of Covered Bond Terms, April 27, 2018