Moody’s Investors Service says that the covered bond market enjoyed strong growth in 2007, but that credit challenges lie ahead in 2008.

A couple of Canadian banks issued covered bonds for the first time last year, but most of the action in this market was in Europe. The overall number of new covered bond programs rated by Moody’s in 2007 was greater than in 2006, with 26 programs across Europe receiving their first Moody’s ratings compared with 24 the previous year.

“The growth in terms of new ratings and outstanding volume of covered bonds was driven largely by the number of new covered bond issuers from both new and established markets,” says Joerg Homey, a Moody’s assistant vice president and analyst. “During 2007, there were more covered bond upgrades than downgrades. To date, many sponsor banks have demonstrated their willingness to strengthen their covered bond structures in order to maintain or improve the ratings of these programs, if necessary,” Homey continues.

All the negative rating actions on covered bond programs in 2007 were due to a downgrade of the underlying issuer or sponsor bank, and Moody’s expects this factor to remain the primary driver of any negative covered bond rating actions in 2008.

While Moody’s expects continued growth in the number of issuers in 2008, volume growth may be more muted it predicts. “Credit challenges lie ahead,” warns Nicholas Lindstrom, senior vice president and team leader of Moody’s covered bond team. “Refinancing risk is present in most covered bonds, and this is arguably one of the defining risks of the current credit crunch. Furthermore, a number of property markets appear to have either reached their cyclical peak or are approaching such a peak, while bank issuer ratings may come under pressure in 2008 due to the more difficult credit environment.”

Although swap spreads in the covered bond segment were affected by the market turbulence in the second half of 2007, the impact has been generally of lesser magnitude than it has for many other fixed-income segments, the rating agency notes. Also, Moody’s says it may seem prudent for banks to have funding alternatives in the current difficult financial markets. “In this context, more issuers are likely to use covered bonds as a funding tool, it predicts.