Fitch Ratings has affirmed Santander UK's (A+/Stable /F1) mortgage covered bonds at 'AAA'.

The Outlook is Stable.

KEY RATING DRIVERS

The covered bonds' 'AAA' rating is based on Santander UK's Long-Term 'A+' Issuer Default Rating (IDR), the various uplifts above the IDR granted to the programme and the overcollateralisation (OC) protection provided through the programme's asset percentage (AP).

The covered bonds are rated four notches above Santander UK's IDR. This is out of a maximum achievable uplift of nine notches, consisting of a resolution uplift of two notches, a payment continuity uplift (PCU) of six notches and a recovery uplift of one notch.

Fitch relies on the highest level of adjusted AP over the last 12 months of 76.8%, which provides more protection than Fitch's revised 'AAA' break-even AP of 97.0%.

The Stable Outlook reflects a five-notch buffer against a Santander UK IDR downgrade.

'AAA' Break-even AP

Fitch's 'AAA' break-even AP of 97.0% (increased from 92.0% previously), which corresponds to a 'AAA' break-even OC of 3.1%, supports a timely payment rating level of 'AA+' and a one-notch recovery uplift to 'AAA'. The break-even AP calculation considers the supplemental liquidity reserve in the asset coverage test, equal to at least 5% of the amount of covered bonds outstanding, hence providing at least 5% additional OC.

The improved break-even AP for the rating is mainly driven by a reduction in the ALM (assets/liabilities mismatch) loss component to -0.4% (from 4.8%), which reflects the impact on the 'AAA' break-even OC of maturity and interest-rate mismatches.

The reduction is primarily due to the recalibration of the applicable refinancing spread levels (RSLs) across all rating scenarios following the updated Fitch Covered Bonds Rating Criteria, published in August 2022. The recalibration has led to a reduction of the factor used to discount future cash flows on the cover assets to derive a present value at which they could be sold once recourse against the cover pool has been enforced.

The credit loss component based on the 'AA+' timely payment rating level is 3.3% (3.8% previously). The smaller credit loss reflects Fitch's application of its most recent UK RMBS Rating Criteria, resulting in an improvement in the weighted average (WA) recovery rate for the cover pool. This is due to an increase in sustainable house price multiples for most UK regions. Combined with updated data for house prices and gross disposable household income, sustainable house prices are higher in all regions except northern Ireland.

Cover Pool Credit Quality

The GBP 22.81 billion cover pool (as at end-October 2022) consists entirely of prime owner-occupied residential mortgages originated in England, Scotland, Wales and northern Ireland by Santander UK.

The cover pool is evenly distributed across the UK, with the largest concentration in south east (21.3%) followed by Greater London (20%) and east Anglia (12.6%) by current balance. Fitch calculated a WA foreclosure frequency of 13.5% for the pool at the 'AA+' timely payment rating level, and adjusted recoveries downwards to apply a 3.2 % floor to the 'AA+' expected loss to account for idiosyncratic risks.

Uplifts

The IDR uplift of two notches reflects that collateralised covered bonds in the UK are exempt from bail-in, the risk of under-collateralisation is deemed sufficiently low, and that a resolution of Santander UK, should it happen, is not likely to result in the direct enforcement of recourse against the cover pool. Furthermore, the presence of large buffers of qualifying junior debt plus internally subordinated debt offers protection to senior obligations from default in case of the group's failure.

The PCU of six notches reflects the 12 months of liquidity protection provided by the 12-month maturity extension applicable to soft-bullet bonds and a 12-month pre-maturity test for hard-bullet bonds. A reserve fund has also been sized to cover three months of interest payments and some senior expenses, in addition to the GPB600,000 available within the fund. Amounts due under the interest-rate swap on the cover assets rank senior to the payments under the covered bond swap, but are not sized in the reserve fund. However, it would become subordinated in case the issuer, acting as asset swap counterparty, defaults.

The recovery uplift is capped at one notch due to the presence of significant pre-swap foreign-exchange (FX) mismatches between cover assets and liabilities. The covered bonds are fully hedged until maturity (including the extension period), but in the event of a covered bond's default, recoveries from sterling-denominated assets, which have a longer weighted average life than the covered bonds, could expose holders of non-sterling-denominated bonds to FX risk.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

The ratings are 'AAA', which is the highest level on Fitch's scale and therefore cannot be upgraded.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Santander UK's 'AAA' covered bonds' rating would be vulnerable to a downgrade if the bank's IDR is downgraded by six or more notches to 'BB+' or below, or if the AP considered by Fitch in its analysis provides less protection than Fitch's 'AAA' break-even AP of 97.0%. The 'AAA' rating would not be vulnerable to a downgrade if the relied-upon AP increases to the maximum AP of 91% incorporated in the prospectus.

Fitch's break-even AP for the covered bonds' rating will be affected, among other factors, by the profile of the cover assets relative to outstanding covered bonds, which can change over time, even in the absence of new issuance. Therefore, the break-even AP to maintain the covered bonds' rating cannot be assumed to remain stable over time.

In December, Fitch revised its Global Economic Outlook GDP forecasts for the UK to -1.2%. While headline inflation will remain very high in 1H23, wage growth is not keeping pace, so households' budgets are still being squeezed. In addition, we expect the Bank of England to continue to increase interest rates to combat inflation, to 4.75% by 2Q23. This has negatively affected and will continue to affect the housing market, and hence the cover pool.

However, the covered bonds rating benefits from a significant cushion between the OC that Fitch relies upon in its analysis and Fitch's 'AAA' break-even OC. The dual-recourse nature of covered bonds means the issuer is liable to pay the bonds irrespective of the performance of the cover pool. And finally, the rating is well-protected by the five-notch buffer against a downgrade of Santander UK's IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

PUBLIC RATINGS WITH CREDIT LINKAGE TO OTHER RATINGS

The rating on the covered bonds is driven by Santander UK's IDR.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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