While issuance of Spanish covered bonds has fallen over the past couple of years, the credit quality of these programs has been improving. 

That’s largely because the share of residential mortgages backing multi-issuer covered bonds is rising, according to Fitch Ratings. Residential loans have outperformed other assets in cover pools. At the close of the first quarter, these loans accounted for nearly 75% of the cover pools behind these transactions. That’s up from 58% at the close of Q1 2012.

The ongoing shift in the makeup of cover pools has been “gradual, but significant,” according to a report Fitch put out in early July.

Covered bonds are a form of corporate debt with recourse to both the issuer and a pool of assets on the balance sheet of the issuer, typically a bank. Because the assets backing the covered bond remain on the bank’s balance sheet, unlike the collateral for asset-backed securities, banks have more of an incentive to maintain high quality assets.

Covered bonds issued by Spanish banks, known as cedulas hipotecarias (CH), are backed by a mix of residential mortgages, commercial mortgages, and loans to real estate developers.  Since the financial crisis, most Spanish banks have actively managed these portfolios. Juan David Garcia, a senior director at Fitch, said banks are retaining the best performing assets on their balance sheets, primarily residential mortgages, while divesting riskier positions, such as commercial mortgages and real estate developer loans, which are more expensive for them to hold.

Partly as a result of the shift in portfolio composition, the average non-performing loan ratio in Spanish cover pools has fallen to 11% from 11.8%, according to Fitch.

Why are residential mortgages performing so well?

 “Commercial mortgage performance is linked to a business’ performance, so the default ratio is linked to the economic cycle,” said Fernando Cuesta, director of funding and treasury at Bankia, Spain’s fourth largest bank.  By comparison, he said, Spanish residential mortgages are less correlated, “as banks have recourse to the value of the house in case of default, and if it is not enough to repay the loan also a second recourse to the rest of the customer properties.”

Bankia has €37.2 billion ($40.8 billion) of outstanding CH transactions rated by Fitch as of April 2015. Residential mortgages make up 81% of the collateral in these deals, commercial mortgages 16%. and developer loans 3%.

Garcia offered another explanation; while both commercial and residential mortgages are backed by real estate, companies have a higher probability of filing for insolvency than families. Also, the foreclosure and recovery process for a business that becomes insolvent is typically much longer and more complex than that of a family with a residential mortgage.

Garcia added that families generally have a more stable stream of income compared with corporate borrowers whose revenue fluctuates with economic conditions.

Fitch’s report offers a third explanation:  Spain’s economy and housing sector are both improving. The rating agency, which affirmed its ‘BBB+’ rating for the Spanish sovereign in April, expects Spanish gross domestic product to rise 2% in 2015 and 2.3% in 2016. It also anticipates that housing prices will stabilize after declining for the past seven years.  

The better credit profile of the MICH transactions prompted Fitch to upgrade 12 MICH transactions by one notch in May. The highest resulting rating was an ‘A-‘for a deal issued 50% by CLCC called IM Cedulas 7, followed by AyT CCG, Series 14- issued 47% by Unicaja- one notch lower at ‘BBB+.’

Fitch also revised the outlook of five MICH deals to stable, and now all MICH transactions have a stable outlook.

Fitch rates €57 billion in MICHs. The total universe of standalone CHs rated by Fitch is €92.7 billion as of March 2015. 

“Preceding bank consolidation in Spain, smaller banks came to market in the booming years using the multi-issuer structure as a way to fund themselves. Now there are six regular issuers, each with total asset size of more than €150 billion, while the smaller banks have assets totaling less than €65 billion. These smaller issuers eventually come to market, typically as single sellers, but not as regularly as the larger banks,” said Cuesta.

Bankia, which was formed in December 2010, is the product of the consolidation of seven Spanish savings banks. The bank was initially owned by holding company Banco Financiero y de Ahorros and went public in July 2011. 

According to Cuesta, cedulas hipotecarias are typically purchased by traditional investors, such as pension plans and insurance companies, as they are low cost, long term funding instruments. “Right now they are trading around 30 to 40 basis points over the mid-swap curve through Spanish government bonds, which is much lower than other types of Spanish bonds,” he said.

Another buyer is the European Central Bank (ECB), which launched its third Covered Bond Purchase Program (CBPP 3) in September 2014. Cuesta said that the ECB has been acquiring about €2 billion a week through purchases in both the primary and secondary market.

“In mid-July, the ECB reached €100 billion outstanding via CBPP 3 and will keep buying until September 2016. By the year-end of 2015, it could reach €160-€180 billion,” he said. 

Despite strong pricing and improving credit, issuance slowed to €28.8 billion in 2013, the most recent year for which data is available from the European Covered Bond Council, from over €100 billion in 2012.

Cuesta said the slowdown is partly attributable to low mortgage origination. “Covered bonds are clearly instruments which play a role in banks’ asset and liabilities strategies because they are cheap way to get long term funding,” he said. “As long as there is still collateral (mortgages or public sector assets), banks will continue to use them.”

An earlier version of this story misstated the outstanding volume of cedulas hipotecarias issued by Bankia.

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