If regional or sub-sovereign borrowers featured in a roster of the worlds largest economies, the German Landof North Rhine-Westphalia would rank 17th, according to research published recently by Deutsche Bank.
Combine the size of the NRW economy with the highly decentralised structure of the broader German economy and it is not surprising that the Land has a chunky annual borrowing requirement of some Eu18bn. Nor is it surprising that it manages that funding requirement in a manner not dissimilar to how several smaller sovereign borrowers manage theirs which means maintaining a commitment to well marketed, responsibly priced bond issuance.
NRWs Eu1bn 2018 benchmark, for example, led by Barclays Capital, UniCredit and WestLB, is described by bankers as prepared and executed in textbook fashion. Launched into a very fragile market in November 2007, the NRW transaction was extensively roadshowed in Asia, with price guidance set at 4bp through swaps. In the event, a book of some Eu1.6bn allowed for pricing at 4.5bp below swaps.
Thomas Stoffer, a director of debt capital markets at Barclays Capital in Frankfurt, says it is not just NRWs high funding requirement that has made it one of Europes most progressive local government borrowers. He points out that the Land is also the guarantor of debt issued by the state development bank, NRW.Bank, which has a similar total borrowing requirement. "Always finding investors and lenders with significant credit lines for NRW can thus become an area of focus for the states treasury," says Stoffer.NRW is not alone. More generally, German Länder have needed to cultivate increasingly durable relationships with institutional investors at home and abroad as their use of the bond market has increased. According to Fitch, while bond issues accounted for just 37.1% of overall Länderdebt in 2002, by 2006 this share had risen to 45.1% and by the middle of 2007, to 46.7%.
"Germany is the all-time champion in terms of local government bond issuance in Europe," says Jacques Dupuis, head of capital market research at Dexia in Luxembourg. "All the Länder issue each year in substantial amounts and because they have built up a solid investor base allowing them to sell their bonds domestically and internationally, they are generally able to issue well below swaps. They usually aim for levels of 5bp or 6bp through swaps for their 10 year deals."
In 2008, bankers expect issuance from the German Länder to be broadly flat. Stoffer says that based on figures published in December 2007, overall gross funding volume this year is expected to be Eu77.7bn, which he says is Eu3bn-Eu4bn less than 2007s total. Very little of this, however, will be new debt.
"The German Länder have about Eu450bn of debt outstanding, much of which is in the six to seven year maturity range," says Volker Anhauser, head of German public sector coverage at BNP Paribas. "Because tax income has been so strong in Germany, much of this years issuance will be refinancing, and some of the Länder such as Bavaria are now even repaying debt on a net basis."
Adventurous Saxony-AnhaltBesides NRW, Saxony-Anhalt has also been well regarded internationally as among the most adventurous European local and regional government borrowers.Having launched a handful of internationally targeted transactions in 1997, Saxony-Anhalts head of funding, Axel Guehl, broke the mould among German regions when he set about modernising the Lands funding strategy, securing ratings from Moodys and Standard & Poors and organising extensive roadshows aimed at wooing European and Asian investors.
The result, in the summer of 1998, was the first rated transaction from a German Land a DM2bn 10 year Euro-Asian bond led by Deutsche Bank and Goldman Sachs.Since then, Saxony-Anhalt has built a reputation for being prepared to test new currencies and structures, issuing the first note linked to Polish inflation, led by Lehman Brothers in March 2006, for example. Before that, in the summer of 2004, Guehl broke new ground when he launched the first Sharia-compliant bond (sukuk) from a European issuer, an Eu100m transaction arranged by Citigroup.
Privately, bankers say the Islamic bond probably consumed more time and resources than it was worth for a transaction raising Eu100m, and is therefore an experiment that is unlikely to be repeated in the foreseeable future by Saxony-Anhalt or any other German region.
Nevertheless, when the textbooks are written on the history of sub-sovereign issuance in Europe, the contribution Axel Guehl made to the modernisation of the market will be worth much more than a passing reference. "Saxony-Anhalt has been notable for adopting the sort of borrowing strategy you would expect to see from some of the more active supranational and sovereign borrowers with much larger funding programmes," says Ralf Berninger, executive director of public sector origination at Dexia Capital Markets in Paris. "It has worked hard on diversifying its funding mix and educating its investor base and has never looked to squeeze out the last basis point in the primary market."Expanding horizonsOther German Länder have also been expanding their horizons, by, for example, exploring longer dated issues. Berlin extended the Länder yield curve in February 2007 when it launched the first 15 year transaction from a German region since the Länderspooled transaction (Länderschatzanweisung No 4) in 1998. Deutsche Bank, Dexia and JP Morgan priced it at 2bp through mid-swaps which, as a case study on the transaction published by Dexia comments, was appealing to the borrower and investors alike. "Locking in such a maturity at a decent price gave Berlin the flexibility to extend its yield curve and optimise its funding," the study notes. "Berlin just paid a 1bp premium to extend its curve out of 10 years, while investors were attracted by a re-offer level that remained just a couple of basis points below Euribor."
To Dupuis at Dexia, another indication of the financial sophistication of the German sub-sovereign sector has been the use by a handful of municipal borrowers of the convertible bond market. Several cities have issued bonds exchangeable into blue-chip German equities.
The largest of these was a Eu129m transaction by the City of Gelsenkirchen, exchangeable into shares of RWE, issued in June 2004 via Dresdner Kleinwort.
Other German sub-sovereigns to have used the mechanism include Brandenburg, with transactions of Eu20m and Eu15m exchangeable into Commerzbank and PPR shares, and NRW, with a Eu40m deal exchangeable into Allianz. The exchangeable technique has also been used by the Cantons of Geneva and Lucerne in Switzerland, and by the City of Milan in Italy.
Barclays Capitals Stoffer says that as well as exploring the full range of institutional sources of funding, a handful of the Länder have also stepped up their activity in the retail-targeted market. "The retail-targeted market in Germany is huge," he says. "In our discussions with WestLB we recognised that we would be able to generate some retail investor demand for capital-guaranteed Länder issues linked to the performance of the Eurostoxx 50 index."
Brandenburg was the first of the Länder to explore this option, says Stoffer, and it has since been followed by NRW, Saxony Anhalt and Saarland, although volumes remain very small. "In the case of NRW we have sold between Eu40m and Eu50m of retail-targeted notes, and the other Länder have sold up to Eu20m or Eu30m, so there is no comparison with other funding sources."As a group the German Länderare now being repaid for the hard work they have done in cultivating a broader investor base. "The Länder have enjoyed safe haven status during the crisis," says Stoffer. "In particular, at Barclays Capital we have seen a lot of demand for shorter dated two to five year transactions from the Länder, especially in floating rate format, which have been very popular among investors looking for safe haven strategies."
The popularity of the Länder as higher yielding proxies for Bunds was clearly visible in the latest benchmark from Saxony-Anhalt, a Eu1bn five year deal via Deutsche Bank, UniCredit and WestLB in April. Priced in the middle of its indicated price range of 3bp-5bp through mid-swaps, the zero risk-weighted Saxony Anhalt deal generated very respectable and geographically well diversified demand of about Eu1.8bn.
"I would say that in the five year maturity Saxony-Anhalt would have come in the minus 5bp area one year ago, so there has been a modest spread widening," says Menko Jaekel, a director in the debt capital markets group at BNP Paribas in London. "So in relative terms there has been a safe haven bid for the Länder."
Spain feels the painNot all sub-sovereign markets have benefited from a flight to quality in the recent market turmoil. Spanish sub-sovereign bonds, in particular, appear to have been caught in the downdraught that has swept across the global capital market over the last year.
"Spreads in the Spanish local government sector have widened slightly against Euribor since the start of the crisis," says Federico Silva, head of fixed income origination and syndicate at Caja Madrid. "In June 2007 the average spread for a 10 year Spanish local government bond was Euribor minus 5bp; by April 2008 this had risen to Euribor plus 5bp. So were talking about a 10bp widening, which is very modest compared with corporates and financials.
"However," adds Silva, "the other notable development since the start of the crisis has been the widening of Spanish regional governments versus the German Bund. Historically, when there was weakness in the corporate bond market as in 2005 with the crisis in the auto sector, the Spanish local governments as well as the German Bund were beneficiaries of the flight to quality. That hasnt been the case this time, because of a perception that the global slowdown will affect Spain more than other European countries."
At a broader level, bankers say that overall issuance of local government and municipal debt in Europe remains disappointing, relative to its potential. Total supply has also lagged behind the surge in total issuance that followed the advent of the euro, which implied that a new, highly liquid and rapidly expanding asset class had arrived, offering investors an attractive pick-up over government bonds.
According to Dexia, a modest 50 local and regional government issues raised Eu9.4bn in 1999. In 2000 this more than doubled to 105 issues worth Eu18bn, a total that continued to power ahead to Eu33bn in 2001 and Eu48.1bn in 2002. Since then, growth has stalled, with issuance reaching Eu29.5bn in 2003, Eu43.8bn in 2004, Eu49.4bn in 2005, Eu47.5bn in 2006 and Eu40.4bn in 2007.
As one example of an economy that has failed to live up to its potential in terms of supply of local government issuance, take France, which is made up of 26 regions, 100 departments and almost 37,000 municipalities. While a number of French municipal and regional authorities have been occasional visitors to the capital market, they have tended to eschew benchmark issuance.
Of the regions, only Ile-de-France has made active use of a Euro-medium term note (EMTN) programme, and in recent years its principal focus has been on the Swiss franc market. Its most recent visit to the public euro market was a Eu220m 11 year transaction priced at 4bp through mid-swaps in July 2006 by Ixis CIB and Société Générale. "Because Ile-de-France does not have a very large financing requirement compared to other European regions, it initially tended to treat its capital market activity as a means of maintaining a communications channel with investors rather than as a strategic funding tool," says Thierry Durand, deputy head of origination at Dexia Capital Markets in Paris. "Only later did it start to use it as an interesting funding complement."
Frances municipal borrowers have also been highly elusive visitors to the market. Triple-A rated Paris, for example, set up a Eu2bn EMTN programme in December 2004 in support of an investment programme of Eu4.7bn for 2004-2007. It has since launched a number of opportunistic transactions in currencies ranging from Hong Kong dollars and Japanese yen to Norwegian kroner.
In more mainstream currencies, Paris has generated solid support for its modestly sized euro transactions. In November 2006, a Eu100m eight year deal led by Calyon and Dexia at mid-swaps minus 5bp was placed 50% with French accounts and the balance to Switzerland, Germany, Belgium and Luxembourg. A year later, Pariss longer dated Eu160m 13 year offer, led by HSBC and Natixis at the same spread of 5bp through swaps, was aimed largely at French insurance companies.
The other French municipalities that have issued in the capital market have done so in tiny amounts, which bankers describe as a disappointment. Marseilles, for instance, sold a handful of bonds in denominations of Eu40m, a programme which one banker says came to an abrupt end when the citys chief financial officer left to take up a similar post at Cannes, which has issued in even smaller amounts.
Elsewhere in Europe, local government issuance has been sporadic. Madrid burst on to the market with a triumphant flourish in July 2002, when it launched the largest ever transaction from a Spanish sub-sovereign borrower with a Eu1.9185bn deal split into 10 and seven year tranches, led by Caja Madrid and Crédit Agricole Indosuez, and a five year FRN via Société Générale. That comfortably eclipsed the previous largest deal from a Spanish region, which had been the Eu500m 10 year benchmark issued by Generalitat Valenciana in 1999.
Since 2002, however, Madrid has been no more than an infrequent issuer. In September 2005 it raised Eu228m in a 10 year deal which came flat to mid-swaps through Citigroup and Société Générale. It followed this up with a brace of transactions in 2006 a Eu279m 10 year deal in June and a Eu179m 15 year in November.
Bankers do not expect a return to benchmark issuance from Madrid in the foreseeable future, given the Spanish capitals commitment to making a speedy return to a balanced budget and reducing its debt burden. As S&P commented when it affirmed the citys AA long term rating last June, "the ratings are constrained by the deterioration of Madrids self-financing capacity over the past several years, driven by the gradual narrowing of the operating margin since 2000 and material debt accumulation since 2003."
S&P added that total tax-supported debt had reached 117% of total revenues at the end of 2006, and warned that "the citys hefty debt burden and high committed expenditures make any ratings upside unlikely in the intermediate term."
Central Europe emergesElusive benchmark deals have also emerged from central and eastern Europe. In June 2005, for example, the City of Bucharests Eu500m 10 year transaction led by ABN Amro and JP Morgan generated healthy demand from investors viewing the deal as a proxy for the Romanian government and therefore as an appealing EU convergence play.
Elsewhere in the region, the Czech city of Ostrava has made one visit to the market, a Eu100m 10 year issue via Deutsche Bank in July 2004. Before that, Deutsche also led a rare transaction for Prague, which tapped the market in March 2003 with its first deal since 1999, when its Eu170m 10 year issue was extensively roadshowed and priced at 53bp over Bunds (or 33bp over swaps).
In the very short term, say bankers, it seems unlikely that more issuers will join the club with benchmark transactions chiefly because of continued uncertainty about how deals from new borrowers in the local government sector are likely to be priced in todays precarious market environment. As Dupuis points out, the Bucharest transaction, which was priced at 105bp over swaps in June 2005, has recently been trading at between 150bp and 170bp over.
Dexias group head of syndication, Alex Benoehr, points to the City of Warsaw as a good example of a potential newcomer that has an eye on the market. The Polish capital was rated for the first time by Moodys in December. The A2 rating and stable outlook reflected a number of factors. These included "favourable socio-economic indicators and a good operating performance in recent years, which has enabled the city to maintain relatively low debt ratios".
Direct access to the international capital market would certainly be welcome for Warsaw. As the Moodys analysis points out, the city is expected to implement an ambitious capital expenditure programme calling for more than Z10bn ($4.6bn) between 2008 and 2010 more than three times the capex realised between 2004 and 2006."Warsaw would be a very welcome addition to the club of municipal issuers," says Benoehr. "But the repricing across much of the market in the last few months has happened very quickly and for some issuers it has been extremely brutal. That has certainly been the case in the market for central and eastern European sovereigns, which had a great run between 2003 and last summer. By the second quarter of 2007, Poland would issue at levels comparable to Italian or Spanish regions a couple of years ago. These spreads would have made the market attractive for a borrower like Warsaw. Since last summer, Polish and Hungarian credit default swap prices and bond spreads have widened substantially and very quickly, and that would obviously have a damaging impact on pricing for the CEE municipalities."