SME covered bonds’ dubious future

Author: Danielle Myles | Published: 3 Dec 2013
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  • Following Commerzbank’s hybrid SME covered bond in February, speculation has mounted over whether the deal would spark the dawning of a new asset class in Europe;
  • But statutory shortcomings and SME loans’ credit risk means it will be a niche instrument issued by strong issuers in well-established markets;
  • Regulators had called on the market to look at capital market innovations, including SME loan-backed investment vehicles, to help plus the funding shortfall plaguing Europe’s economic recovery;
  • But market participants note that if a SME covered bond sector does emerge, it will not be for some time, meaning more immediate funding solutions are needed.

Covered bonds backed by loans to small and medium-sized enterprises (SME) will remain a niche product of established issuers from mature markets.

Regulators have urged the market to innovate capital market solutions to fill the SME funding gap plaguing Europe’s recovery. But industry participants have made clear that, in addition to structural and asset quality challenges, the amount of time needed to establish an SME covered bond sector means it is not an immediate funding solution.

SME covered bonds have been a hot topic since Germany’s Commerzbank unlocked the sector with its €500 million ($679 million) deal in February.

"I agree the structure is very smart and I can imagine other issuers in the core countries using it, but I wouldn’t think about such a structure issued out of peripheral countries," said Pimco covered bond portfolio manager Timo Boehm, speaking at the Association for Financial Markets in Europe’s covered bonds conference in Berlin on Friday.

With €1.5 trillion of outstanding SME loans in Europe, some query whether the covered bond market is missing a trick.

But while panellists agreed it would remain an area to watch in 2014, they do not expect it to amount to a new segment of the market.

Statutory shortcomings

The major obstacle is that the vast majority of covered bond legislation across Europe, including in countries amounting for the greatest volumes, is firmly geared towards mortgages and public sector loans. This means that other types of assets, including SME loans, cannot be included in cover pools.

Commerzbank’s landmark deal sidestepped this problem through the use of a contractual structure, which replicated the parties’ rights and obligations under the Pfandbrief Act.

As such, many – including investors – believe it is a misnomer to call them covered bonds.

"We are clearly in the camp that we are talking about structured covered bonds," said Boehm. "We generally acknowledge the product and new investment alternatives, but we don’t want to have such a product on an existing covered bond law."

According to Ralf Grossmann, head of covered bond origination at Société Générale Corporate & Investment Banking, the key features of any SME deal must be dual recourse, a high level of transparency, and over-collateralisation.

There was discussion in France earlier this year about legislating for SME covered bonds, but this was not expected to be formalised into a bill anytime soon. Spain is now contemplating changing its law to make SME loans eligible as cover pool assets.

For less developed covered bond markets, however, SME-backed deals are not likely to feature any time soon. Oliver Koepke, head of treasury at Poland’s BRE Bank, said this new breed of covered bond would be difficult from a legal and tax perspective under the country’s legislation, and so other ways to improve SME funding would be considered first.

It should be noted that Turkey is an anomaly in this regard. Its 2007 covered bond law makes SME loans eligible cover pool assets, and a number of banks have issued such bonds over the past 18 months.

Market challenges

Statutory shortcomings aside, SME covered bonds face market-based impediments.

Issuing banks must be happy to take the credit risk, which can be substantial given that SMEs’ default rate is significantly higher than traditional cover pool assets.

How investors assesses these deals could also prove an obstacle, with their focus moving away from the cover pool and towards the credit of the issuing bank.

"We must keep in mind the asset quality is completely different [to mortgages]," said one buyside panellist, noting that Commerzbank’s rating would have contributed significantly to the February deal’s success.

Nonetheless, panellists agreed that such instruments would be interesting to sophisticated investors. "Given low interest rates will remain for some time, some large investors would significantly benefit from access to a more developed set of investment vehicles and opportunities related to SMEs," said the European Central Bank’s (ECB) Philipp Hartmann, (speaking in his own capacity) delivering the conference’s keynote address.

Holistic SME funding

Grossman and Boehm agreed that SME covered bonds are not an immediate solution to Europe’s funding problems.

"We are just at the starting point and it would take a long time to develop this [market]," Grossmann said. "So it is not something to help SMEs right away; it would take some time."

As such, there are more pragmatic ways to arrange cheaper and quicker funding for the sector.

But Hartmann noted that as the ECB cannot intervene to directly resolve the problem, market-based solutions forcing a shift from today’s reliance on bank lending towards capital markets is needed.

"The ECB can only do so much in this regard, we quickly reach our limits, so we need a holistic approach to address this," said Hartmann. "Some are closer to your business and some are closer to ours….innovation in the capital markets is really called for in that regard."

"I have read about reservations about the role of covered bonds here, and what is possible on the ABS [asset-backed securities] side," he said. "But I do think a flexible financing system that can shift between different sources of financing, and a greater role of capital market financial instruments does play an important role here."

"This is up to market innovation to a large extent, with some support of public authorities on the fair regulatory treatment and maybe offering other types of supports including the treatment of other types of support, such as the debt treatment in our collateral framework," he added.

In addition to the ECB’s collateral programme and inclusion of SME loans in covered bond pools or securitisation structures, Hartmann’s recommended holistic approach to SME funding includes:

  • implementation of the banking union, to help stop the funding discrimination faced by SMEs in stressed countries (due to their being associated with the sovereign);
  • enhanced data transparency for SMEs to help structure pooled investment vehicles consisting of small loans which, today, are hard to verify credit standing;
  • fostering joint efforts of development banks in different countries;
  • more private equity and venture capital initiatives;
  • fostering a stronger private placement market;
  • mini bonds; and,
  • exchanges for small cap companies.

Related links

The structure behind Commerzbank’s SME covered bond

Can European covered bonds count as tier 1?

ICMA: covered bonds’ next generation

Covered bonds guide 2013