The unveiling last week of the first SME-backed covered bond programme by a major European bank has raised questions about the product’s potential and target audience, and whether it should carry the covered bond moniker even if it will miss out on the industry’s new label.

Plans by Germany’s Commerzbank to issue structured SME-backed covered bonds came out into the open last Thursday (6 December) when Fitch and Moody’s published provisional ratings, AA and Aa2, respectively, of the bonds, although rumours had been circulating for around a year that the bank, and one or two of its peers, would make such a move.

The only SME-backed covered bonds to date have come from Turkey, where they are permitted under covered bond legislation.

In Austria draft legislation amending the country’s covered bond legal frameworks foresees the introduction of legal based SME-backed covered bonds. The intention is that these would be called fundierte Schuldverschreibungen to distinguish them from mortgage and public sector Pfandbriefe, as all covered bonds backed by these types of collateral will be known following a planned harmonisation of the country’s three covered bond legal frameworks.

In Germany, because SME loans and subordinated property finance (the part of a loan above a 60% LTV cap) do not qualify as collateral for Pfandbriefe under the Pfandbrief Act issuers “need to blaze new trails to exploit these underutilised asset classes”, says Jörg Homey, head of covered bond research at DZ Bank.

Aside from Commerzbank’s structured covered bond, HSH Nordbank is able to include SME loans in its cover pool after they gained a guarantee from Germany government agency KFW via a securitisation transaction launched under the development bank’s Promise 1 platform.

The potential for an SME-backed covered bond market to develop hinges on factors such as investor demand, the stock of collateral, and regulatory and political support, according to market participants.

Some believe that Commerzbank’s programme is the start of something big – or should be, at least.

Their reasons include that SMEs are a vital component of the European economy yet highly dependent on bank loans and credit lines, so the introduction of bank funding products that can help channel credit to the SME sector should be welcomed.

In speech on small business financing in Frankfurt yesterday (Thursday), ECB executive board member Benoît Cœuré noted that SMEs constitute around 99% of all euro area firms, employ around three-quarters of the euro-zone’s employees, and generate around 60% of value added.

Richard Kemmish, head of covered bond origination at Credit Suisse, says that any product that facilitates a flow of funds into the SME sector has to be positive and will, or should, get enormous political support.

“Whatever we call them, Mittelstandsbriefe, cédulas pequemo y medianas emprese, Obligations Petit et Moyen Entrepreneur, white-van covered securities, I suspect we will be seeing a lot more of them,” he says.

If deemed to represent high quality liquid assets (HQLA) SME-backed covered bonds can also play an important role in helping European banks meet Liquidity Coverage Ratio (LCR) requirements under upcoming CRD regulation, adds Kemmish.

“Half of me thinks that the product should not get preferential treatment as an HQLA for the purposes of bank liquidity ratios without the backing of a dedicated regulatory regime,” he says, “and the other half of me says that the desperate shortfall of HQLA assets in the European banking system demands that it should.”

Others play down the mainstream potential of SME-backed covered bonds.

“I think it will stay a bit of a niche product,” says Ralf Grossmann, head of covered bond origination at Société Générale. “From an asset encumbrance perspective Commerzbank could afford to use SME loans as collateral and there may be some other banks that look at this, but overall the available stock of assets to be mobilised is relatively limited and I don’t expect it to be a very large market.”

Nonetheless, it is understandable that issuers would like to mobilise assets to obtain cheaper funding, he adds, and an SME-backed covered bond is a way to do this. The product also makes sense for investors, he says, with the Commerzbank programme having shown that high ratings are possible and the product also offering diversification and a spread pick-up over Pfandbriefe.

Moody’s Aa2 rating of Commerzbank’s SME covered bond reflects a four notch uplift from the issuer rating (A3), with a Timely Payment Indicator (TPI) of “probable” providing for a two notch buffer in the event of a downgrade of the issuer. Fitch’s AA rating incorporates a smaller uplift, of two notches, from the issuer rating (A+).

Not so much for the traditionalists

Christoph Anhamm, head of covered bond origination at RBS, says that particularly in the case of SME-backed covered bonds issued outside a dedicated legal framework, the collateral will be the most important factor defining the investor base. And in the case of SME-backed covered bonds, it is likely to be a limiting factor, he says.

“The investor base should be a mix of accounts – some senior unsecured investors, some traditional covered bond investors and those who are familiar with SME loans through ABS,” he says. “The investors who are likely to be involved are those with a certain minimum degree of understanding of the SME loan asset class, which should limit the potential audience as there is only a limited number of investors with SME experience and an opinion on the covered bond structure.”

NordLB analyst Matthias Melms says that investor acceptance is unclear, but that the last few months have shown that the market is well disposed towards new products.

“We are therefore convinced that investors will take a close look at potential issues,” he says.

Pricing will of course have an impact on how investors take to the product and Frank Will, head of covered bond strategy at RBS, suggests the prevailing low rate environment may be fertile ground for the introduction of a new product such as SME-backed covered bonds.

“Investors are desperate for yields so if they see something where they can get a little bit more return, there is potential there,” he says. “It will clearly come wider than mortgage covered bonds, but besides that there are a lot of question marks, and it will depend a lot on the quality of the loans and maybe even more importantly what the prospectus allows to be put in an SME covered bond.”

The general prediction is for a structured SME-backed Commerzbank covered bond to be priced somewhere between the issuer’s unsecured debt and Pfandbrief spreads of Hypothekenbank Frankfurt, with NordLB’s Melms putting the mean between these curves at around 50bp over mid-swaps for a five year deal. This is the maturity that a first issue is expected to have, according to rating reports. A banker ventured that investors would be “well served” with a spread of 40bp over mid-swaps.

Naming convention disgruntles

But there is another discussion to be had, it seems, and that concerns whether the debt that Commerzbank plans to issue, with others possibly following, should be called a covered bond.

RBS’s Will says that care needs to be taken in labelling the product as a covered bond as it could dilute the well-regarded brand name.

“If you use SMEs then why stop there and not take other loans, leasing, credit cards, etc?” he says. “But on the other hand as long as investors are aware of what they are buying it is up to them.”

A Commerzbank spokesperson told The Covered Bond Report that it would not do anything to damage the German legislative product and that the clear distinction between the two instruments would safeguard this.

Any SME covered bonds launched by Commerzbank off its programme will not qualify for an industry covered bond label that a European Covered Bond Council institution will begin awarding next year. This is because they are structured on a contractual rather than legal basis and because they are backed by SME loans rather than mortgage, public sector and/or ship assets. Because they are not Ucits-compliant they will not be eligible for repo with the ECB on the same favourable terms as Ucits-compliant covered bonds.

For one investor, the term covered bond should be kept out of the picture in relation to Commerzbank’s new funding instrument.

“I have no problem with the product and if it offers value, I’m in, but I would look it as a structured dual recourse bond and not a covered bond,” he says. “If the vdp is happy to add it to the Pfandbrief law and European regulators to CRD then OK, it’s a valid point, but if this is a one-off issue or niche market just trying to piggyback on a bull market for covered bonds then I’m slightly negative.

“This is a structured product and has to be approached as one – there’s no complacency to be had in the process.”