There will be no rating impact on UK covered bonds from the Bank of England’s (BoE) decision to cut its base rate this month as our affordability and cash flow analysis use stressed interest-rates, Fitch Ratings says.
The cut in the base rate to 0.25% from 0.50% on August 4 will improve affordability for some mortgage borrowers in the short to medium term, but the impact on Fitch’s affordability analysis will be minimal as this is calculated using an assumed stressed interest rate. Cash-flow analysis will not be affected as Fitch models both high and low stressed interest rates and takes into account the interest-rate swaps in place for most programmes.
The lower base rate has a direct impact for borrowers on a tracker rate or on a standard variable rate (SVR) where lenders have decided to pass on the cut. All 12 UK covered bond issuers have said they will cut their SVRs by 25bp from September or October 2016. Following the reduction, the UK SVRs on residential mortgages will range between 3.7% and 5.4%, compared with 3.9% to 5.7% currently.
For the 13 UK covered bond programmes rated by Fitch, the current portions of SVR and tracker-rate loans in the cover pools average about 30% and 25%, respectively. These borrowers will benefit from lower repayments on their mortgages. However, Fitch’s affordability calculation for UK cover pools applies a stress of 4% Libor plus the margin of the mortgages’ stabilised interest rate over Libor. As such, the borrower’s stressed credit risk calculation will be broadly unchanged.
In our cash-flow analysis, the lower rate paid by some borrowers will not result in lower excess spread for UK covered bonds programmes, as interest payments on cover assets and covered bonds are usually swapped into a floating rate (Libor) plus a fixed margin. For unhedged tracker-rate loans, Fitch assumes a haircut on the tracker-rate loan spread to reflect a risk of potential variation in the spread between the base rate and Libor.
In its analysis, Fitch also accounts for a reduction in the spread between SVR and Libor from current levels. Fitch assumes that SVR will over the long term be 2%-3% above Libor, as the margin between the two may narrow if rates rise.
Some legacy SVR loans are capped at 200bp over the base rate, notably for Nationwide Building Society and Lloyds Bank plc’s covered bond programmes (about 37% and 60% of cover pool balance, respectively). When this cap is reached and the base rate is low, both SVR and tracker-rate features of the loans have been considered under Fitch’s cash-flow analysis.
Fitch’s view remains that UK covered bond ratings are resilient to the new environment created by the decision of the UK to leave the EU. (See “UK Covered Bond Ratings Resilient to Brexit Vote” dated 1 July 2016.) However, ratios of property prices to incomes in the UK are well above their long-term trend, especially in London. Fitch’s credit-loss analysis on mortgage loans assumes prices will revert to a sustainable level in the longer term. Lower mortgage payments from the lower base rate, while likely to help mortgage performance in the short term, do not alter our long-term credit view.