RBS managing director, International Capital
Market Association (ICMA) board member, and covered bond
specialist Tim Skeet discusses recent market developments and
the asset class’s future
What factors should an investor consider when choosing
between Residential Mortgage-Backed Securities (RMBS) and
Covered bonds share certain fundamental characteristics with
RMBS – the bankruptcy remoteness, and the ring fenced
assets, for example.
RMBS are typically a risk product. The robustness of the
structure and the creditworthiness of the underlying assets are
key. And as such deals typically have amortising structures, a
lot depends on individual risk and cashflow appetite.
Investors that want to buy that sort of instrument must look
to where the product sits in the credit structure of a
particular transaction, and understand the degree of risk
within that structure and consider maturity risk. But above all
they need to form their own view on the creditworthiness of the
underlying assets because that's what's going to get them
In contrast, covered bonds are dual recourse; the issuer is
the primary source of repayment, not the underlying assets. The
product is therefore relatively credit-lite as investors need
to take a view first on the issuer, and then on the underlying
collateral as back-up. The note itself is equivalent to the
'super senior' class of RMBS in many respects, but without the
option to buy more subordinated pieces.
Covered bonds also have bullet maturities, which means the
cash flows are much more predictable. That said there's quite a
lot less spread on a covered bond compared to RMBS.
The level of legal support available for the two products is
also crucially different. For RMBS, investor rights are
typically contractual. In contrast, covered bonds are defined
by law. Investors can thereby take comfort in the statutory
protection offered by the instrument.
What are your views on the European Covered Bond Council
(ECBC) covered bond label and what benefits do you think it
The labelling initiative pioneered by the ECBC, is based on
a simple philosophy – to clearly define what is, and
what is not, a covered bond. Helpfully it also specifies
minimum levels of disclosure as well as characteristics, such
as the underlying asset classes. Labelling will hopefully lead
to a discernible price advantage in future.
rage around the use of the expression 'covered
Defining the product is an ongoing challenge for the market.
Such a definition needs to encompass all the variations in
jurisdictional practices and market idiosyncrasies, while still
preserving the traditional covered bond concept as defined
under European practice.
Under the Anglo-Saxon precedent, it's possible to use the
term 'covered bond' for a range of instruments, because it's
not trademarked in any way. Linguists note that the term
'covered bond' is a far more generic term than the closely
defined 'pfandbrief' and is therefore in reality a
poor translation of the original German concept.
The industry therefore rightly wants to find a way of
ensuring investors know that if they buy a covered bond,
they're buying an instrument that's extraordinarily safe.
The ECBC's project seems to have been well accepted.
Everybody realises why they need to do it – it's a
sensible and logical precaution to prevent future reputation
risk or abuse of the structure. After all, it's concerning that
reputational damage could be caused to covered bonds in the
event of a future crisis, through irresponsible repackaging of
intrinsically-risky assets masquerading as riskless or low-risk
Issuers in some jurisdictions are looking at new cover pool
asset classes such as SME loans. What are your thoughts on this
development? Do you think other asset classes could be eligible
for inclusion in the cover pool in future?
This goes to the heart of what the labelling project is all
"The ECBC label
initiative is a sensible and logical precaution to
prevent future reputation risk or abuse of the
Prior to March 2008, contractual covered bonds were issued
in the UK. The move prompted severe criticism, primarily from
the German market – the traditional home of covered
bonds and the pfandbrief.
Critics believed these contractual covered bonds did not
conform to the norms as required by the market, or offer as
much investor protection, and called for the introduction of a
specific UK covered bonds law. The UK subsequently introduced
the Regulated Covered Bond Regulations in 2008.
Fast-forward a few years, and we now have a new type of
covered bond – the SME-backed covered bond, in which
the underlying assets are small corporate loans. It is the
furthest we have been from the original concept. It is
structured around an asset class that is much more difficult to
understand and evaluate. The risk dynamics are thereby very
different from those of a traditional covered bond, which is
structured around highly granular and well-understood real
estate assets or public sector loans.
Opinion is divided as to what this instrument is. Some view
it as a 'covered bond'. Others consider it to be a form of
asset-backed that shares certain characteristics with covered
bonds – namely bullet redemptions, and a dual recourse
funding mechanism – but without the specific legal
More traditional market participants might be reticent to
buy into the product's format and associated risk, if they do
not view it as a 'covered bond'.
asset class in SME 'covered bonds’ is much
more difficult to understand and evaluate"
The debate will continue to rage around the use of the
expression 'covered bond'. The ECBC labelling initiative aims
to lift such debate into a different place – a
labelled covered bond is a historic covered bond, an unlabelled
one, therefore, is not.
But irrespective of investor reception, there is currently a
notable regulatory focus on sourcing new ways to accelerate the
flow of funds to SMEs and European companies, in particular.
There are growing concerns among EU regulators about the
ability of such entities to refinance, given banks' recent and
ongoing retrenchment from the loan market and dramatic
In such a context, market participants look to covered bonds
as a form of quasi-securitisation that appeals to a broader and
deeper investor base.
But it's questionable whether the name of the product
matters, in a world where investors are expected to more
closely assess each instrument themselves.
Arguably it's up to them to decide what are the products
they will or will not buy and the names they give to them.
It remains to be seen whether the creation of SME-backed
covered bonds in some way compromises or undermines the
robustness of this market. That's the existential question in
So do you think we should call these instruments covered
It was a German institution that successfully created the
first of these, and in a sense that answers the question.
SME-backed covered bonds do behave more like traditional
covered bonds, with the exception that the underlying asset
class is different, and more difficult to assess.
levels of transparency are vital"
I supported the original contractual-based UK covered bonds
but equally, I worked hard to get them pushed into a legal
framework. Certainly, intellectually I like the idea of
SME-backed covered bonds. I like the idea that we can get
investors to buy a dual recourse instrument that they will see
as less risky than outright securitisation, which gives them
more yield, but also provides a mechanism for directing
financing to a vital part of the European economy.
Increased levels of transparency are critical to ensuring
there is adequate disclosure of risk to investors. We need to
make more information readily available for investors, so they
know what they are buying and can both evaluate and price that
risk on a sustainable, consistent basis.
Consider what other sources of finance could plug the
current funding gap for SMEs. There are a number of important
dynamics to contemplate here. And for several major investors,
banks have unique attributes in this regard, that are difficult
to replicate elsewhere.
For example, banks are able to leverage themselves up. They
are also often best placed to evaluate the risk associated with
funding these small, often unknown, companies, given their
historic relationships with, and lending activity to, these
entities. Therefore they need to be involved in processing and
assessing the lending.
Further, banks are well placed to restructure the loans in
the event of difficulties or default. That's an important
factor, given SME loans have a higher relative default rate and
less reliable historic performance data compared to the more
usual underlying assets for covered bonds.
A covered bond, by its very nature, is constantly
substituting good assets for bad, thanks to the fully dynamic
nature of the collateral pool. Assuming that the issuer is
still healthy and functioning, the nature of the collateral is
always going to be high quality because the bad loans will come
out and good loans will go back in. You need to have
institutions with the ability to warehouse a certain volume of
Regardless, I think we're likely to hear more of these forms
of assets in the future. The market is becoming more
sophisticated. Its participants should not worry excessively
about instruments' labels but rather they should focus on
analysing the real nature of the risk. That's desirable and
hopefully the direction of travel for investors in future.