Tighter spreads on Spanish covered bonds have not appreciably mitigated the risk of holding this paper, according to Moody’s Investors Service in a special comment released today.

“Liquidity and funding pressures will continue to constrain banks’ credit profiles over the coming months because of the banks’ high reliance on wholesale funding,” the agency said. In addition, the financial pressure faced by the Spanish government can pass through to the creditworthiness of local covered bonds.

In Spain, a mortgage covered bond enjoys the backing of the issuer’s entire mortgage book.

Moody’s presently has an ‘A3’ country ceiling on Spanish covered bonds. While improbably, things could get sharply worse for this euro-denominated instrument. “We believe that the materialization of event risks, such as a currency redenomination of Spanish covered bonds — although we do not currently consider this as a scenario with a material probability — would entail severe losses that could not be protected by any level of over-collateralization.”

The agency also believes that in the event of an issuer bankruptcy, the odds that it would make timely payments on its covered bonds dip below 50%. This is partly due to the bullet structure of these instruments.

While tighter spreads have meant cheaper funding for stronger Spanish banks, their benefits have not filtered down to everyone.  So far this year, Spanish banks have issued €6.2 billion ($8.1 billion) in mortgage-covered bonds. High profile names such as BBVA, Santander and Caixabank were among the issuers. The senior bonds have all reached investment grade.

Moody’s pointed out that the spreads on Spanish covered bonds have moved tightly in sync with those on Spanish treasurys, which shows that the market sees a strong correlation with their risks. (See below).

This correlation does not exist for the covered bonds in Germany.

In general, Moody’s expects non-performing loans in Spanish cover mortgage pools to rise and housing prices to keep falling.

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