Moody’s expects SME backed covered bond usage to expand and feature in countries such as Italy, Spain and France, it said yesterday (Wednesday), noting that the new instruments carry some advantages over traditional ones and will not necessarily be assigned worse scores.

“Covered bonds backed by loans to small and medium-sized enterprises (SMEs) are gaining traction as a new funding tool for European banks,” said the rating agency. “In our view, the reasons are (1) the need of SMEs to find alternative funding sources, especially given the lack of bank financing and the current relatively low level of investor demand for SME asset-backed securities (ABS); (2) the apparent current market preference towards secured debt instruments; and (3) the favourable regulatory treatment of covered bonds.”

In its report Moody’s noted trends that have recently been highlighted by policy-makers across the European Union, particularly the European Central Bank, showing the challenges faced by SMEs.

“The lack of credit availability has been a key factor affecting SMEs’ weak performance since the beginning of the economic crisis in 2008, especially in the most troubled economies, combined with increased funding costs and the tightening of the associated lending conditions,” said the rating agency. “SMEs in stressed countries face worse borrowing conditions than similarly risky competitors in non-stressed countries, given the fragmentation amongst euro area countries.”

Moody’s said that several countries have introduced measures to help SMEs and that the European Investment Bank has increased its lending capacity, but it also highlighted how outstanding volumes of SME ABS have fallen progressively since a peak in the first quarter of 2009.

Covered bonds have meanwhile come into favour among investors and enjoyed regulatory support, said Moody’s, with investors possibly preferring the dual recourse nature of covered bonds while policy-makers are potentially exempting covered bonds from bail-ins and central banks are treating them favourably as collateral, for example.

“In the SME space, the ECB’s recent categorisation of Commerzbank’s SME CBs as assets within the Eurosystem’s collateral framework leads to a more favourable treatment of SME CBs relative to senior unsecured debt and ABS, which could provide further momentum for developments in other euro area countries,” added Moody’s.

Three types of SME covered bonds have thus far been issued, according to Moody’s: law-based SME covered bonds, for example out of Turkey since 2011; contractual-based issuance, namely a Commerzbank deal in February; and covered bonds where SME loan receivables are guaranteed by a public sector entity to make the collateral eligible to back public sector covered bonds, a method used by HSH Nordbank via a guarantee from KfW.

Differences between SME covered bonds and more traditional versions of the asset class are addressed in three ways during Moody’s analysis, it said: by determining the collateral score of the cover pool; by assessing refinancing risk; and by reviewing interest rate and currency mismatches, cash commingling and set-off risks influencing expected loss.

Moody’s said that collateral scores for SME portfolios tend to be higher than for mortgage portfolios in the same country, reflecting lower credit quality. It said the main reasons for this are that: the security provided by residential properties in mortgage portfolios is typically higher than in SME portfolios where portions might have no or lower quality collateral; residential mortgage pools are more highly diversified and granular; and households are typically more resistant to a credit crisis relative to SME credits.

However, the rating agency noted that SME covered bonds are not necessarily riskier since the level of protection available – such as overcollateralisation and other risk mitigants – also has to be considered.

Regarding refinancing risk, Moody’s said that in transactions it has rated so far (from Turkey and Germany), this has been well mitigated because of long extension maturities and pass-through structures that avoid the forced sale of assets.

“The refinancing risks observed in SME covered bonds could be even lower than in traditional covered bonds depending on the structure decided by the issuer,” it said.

Moody’s said that, based on three major components that determine refinancing risk, the level of refinancing risk in an SME cover pool can be characterised thus: the average life of the refinancing risk is shorter, because SME loan receivables usually have a shorter duration than traditional residential mortgage loans (although this could lead to reinvestment or replenishment risk); refinancing margins are higher, because SME loan receivables offer less protection than mortgage loans in terms of security and their performance is highly correlated to the country’s economy; and a smaller cover pool portion is exposed to refinancing risk.

Moody’s said that it rates the effectiveness of credit protections irrespective of whether they are added through law or contract. However, it said that it considers that recognition of SME covered bonds within a specific legal framework could strengthen the debt instrument’s systemic importance and thus improve their refinancing potential.

The rating agency also noted that Timely Payment Indicators (TPIs) for SME covered bonds would not necessarily be worse than those assigned to traditional covered bonds. It highlighted that TPIs assigned to Turkish SME covered bonds have been “probable” or “probable-high”, similar to TPIs for traditional covered bonds in some highly rated countries, such as the UK or France.