ICMA: covered bonds’ next generation

Author: | Published: 10 Jul 2013
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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?

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.

Tim Skeet, ICMA

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 repaid.

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 will offer?

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.

"Debate will rage around the use of the expression 'covered bond"

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 covered bonds.

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 about.

"The ECBC label initiative is a sensible and logical precaution to prevent future reputation risk or abuse of the structure"

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 framework.

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'.

"The underlying 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 deleveraging.

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 some ways.

So do you think we should call these instruments covered bonds?

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.

"Increased 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 these substitutions.

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.

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