Spain is changing its covered bond law to make small and medium enterprise (SME) loans eligible as underlying collateral, expanding what most investors think of as covered bonds and changing the risk profile. The idea is to improve lending to SMEs, which will be an important part of Spain’s recovery, but it opens the door to all kinds of new ‘covered bonds’ and market confusion.

Importance of SME loans for Spanish industry

“It should be stated how important the SMEs are for the European and especially the Spanish industry. It should be obvious that the share of SME on enterprises in general is extremely high. More importantly, however, is that the share of employment within the SME market is very high in Spain, with more than 75% working in such entities,” writes Citi analyst Michael Spies.

Interest rates to Spanish SMEs are falling, but they are still higher than in core EU countries. SME loan demand has been improving, but lending standards have also been tightening. With so much riding on healthy SMEs, it’s no surprise that the Spanish government is willing to give banks more leeway to encourage SME loan growth.

sme interest rates 1113 euro area bank standards, loan demand 1113

Law based SME backed bonds

The difficulty is in figuring out what how risky these new covered bonds are and what kind of investors should be looking at them. Spies guesses that they should fall in between normal covered bonds and senior debt. “We think that traditional covered bond investors will not be the main investor base for law based SME backed bonds. We would rather suspect that ABS investors will be the applicable investor group,” he writes.

His bigger concern is the potential loss of quality that comes from too much fragmentation. If SME loans are used as underlying collateral, there’s nothing preventing other government from extending the law to allow ever riskier forms of credit to back ‘covered loans,’ with the name losing some of its meaning with each change.

“In order to assure that covered bonds continue to enjoy preferential treatment, we believe a harmonization in the context of the traditional asset classes should be a main goal for the industry,” writes Spies. “This should exclude SME loans for which ABS are perceived to be made for in our view.”