Schuldschein banks must keep quality up as money floods in
Foreign investors flocking to the Schuldschein market are drawing in issuers and forcing margins lower. As demand from overseas drives the swelling supply, Silas Brown asks: will the market be able to preserve its traditional strengths as it accommodates new investors?
The variety of investors in the Schuldschein market is shifting.Sparkassen, the German public savings banks, previously dominated demand, using the product to invest in the traditional Schuldschein borrowers from Germany’s industrial base.
But they are becoming less prominent as the Schuldschein gains fame overseas. These investors’ share of the market, according to Helaba, fell to 39% last year.
Commercial banks, both international and domestic, are increasing their involvement, investing roughly €9bn in the market in 2016 — most of which went to international issuers and investment grade German firms.
When Porsche, the German luxury car maker, printed a €1.1bn Schuldschein in February 2016, some 45% of the paper went to international banks — a different complexion from Porsche’s previous Schuldschein transaction in 2011, almost all of which was bought by German investors.
But the rise of the international banks is not the full story of the Schuldschein investor. The number and variety of lenders in the Schuldschein market is much larger than those in other private debt markets, reflecting the allure of the product.
Agencies, co-operative banks and institutional investors all contributed to the record €26bn volume in 2016, up from €21bn in 2015.
The product’s format accommodates the tastes of a rich mix of lenders. Investors are offered a range of tenors, from three to 10 years typically, in fixed or floating rates, and sometimes with an array of currencies.
Issuers, moreover, accept ticket sizes as small as €500,000, which allows smaller investors into the market — perhaps the only opportunity for these investors to lend to investment grade companies.
Institutional investors, seeking to match their liabilities, dominate the longer tranches. Commercial, co-operative, and savings banks control the shorter end.
“Banks and institutional investors do not ‘cannibalise’ each other, as banks are limited on tenor,” says Helaba’s head of primary markets, Andreas Petrie, in Frankfurt.
Declines in European loan market volumes mean international banks are taking more of an interest in the Schuldschein product.
“The benefit a bank might have investing in Schuldscheine, as opposed to term loans, is it can pick and choose from a range of credits, sectors and a range of maturities,” says ING’s head of Schuldschein, Klaus Pahle, in Frankfurt “Also, the bank might feel comfortable investing alongside others with a smaller ticket.”
The credit they deserve
The Schuldschein product has bred a buy-and-hold investor community, proud of its rigorous credit analysis, and distant from the regular concerns of the public bond market.
“Schuldschein actors are paying less attention to Greece’s debt situation, but more to whether Lufthansa is a quality credit,” says Petrie by way of example.
Deals are not listed on a stock exchange, and a secondary market barely exists, so credit analysis takes precedence over geopolitics.
“Schuldschein spreads are more predictable than bond prices,” says Petrie. “Bond market spreads are affected by geopolitical events like Brexit — the Schuldschein is dislocated from that.”
The focus on an issuer’s credit quality traditionally meant investors favoured stable, known credits. But growing levels of unusual foreign issuance have increased concerns that overseas investors are not applying the same analytical rigour to prospective borrowers.
“New lenders should not assume the quality of the credit on the reputation of the Schuldschein,” says one Sparkasse investor who did not wish to be named.
And, as investors drive down price margins, the returns offered by lower rated credit look more attractive.
“Schuldschein investors are opening up to the cross-over area,” says BNP Paribas’s Schuldschein specialist, Raoul Hessling.
Should we keep it light?
Unlike USPP documentation, which is often forbiddingly extensive, Schuldschein documentation seldom exceeds 20 pages.
Basic expectations between investors and issuers are laid out in the German Civil Code — the legal basis of a Schuldschein contract.
Borrowers often select the product for its light documentation as, beyond the obvious advantage in crises, quick execution and minimal legal fees are attractive.
Strong credit research, participants say, is therefore essential for investors and arrangers.
“Arrangers tend to pre-select the Schuldschein-capable companies out of their client portfolios. Up to now, Helaba’s arranged no deals that have defaulted. It is not a market for single-B, or even double-B, names — investors don’t look at the size of the proposed company, but the credit quality,” says Petrie.
However, there is, in the Civil Code, little protection from issuer insolvency. But investors, some say, do not consider light documentation a downside.
“The investors are comfortable with the lean documentation of a Schuldschein,” says Jörg Stührwohldt, managing director of corporate origination at UniCredit in Munich. “This type of documentation eases the monitoring efforts and is similar to a standard investment grade bond documentation in some cases.”
There is sense to light documentation in the traditional areas of the market, where investors have deep ties with the borrower and can better assess the company’s credit profile.
But the market’s reputation could suffer if international banks, investing in cross-over credits, fall victim to a wave of insolvencies.
The arrangers’ role to prevent this is substantial. They act as gatekeepers to the market, vetting companies before a Schuldschein is launched.
“One has to pay attention to who is arranging the loans, and whether they are engaged in pre-selecting issuers,” says Pahle.
Lack of careful pre-selection led to a German minibond crisis in 2011, when mid-sized Mittelstand companies began issuing public bonds.
The deals, with similarly light documentation, were directed at retail investors, attracted by the 5%-10% coupon range.
There was a wave of defaults. By 2015, some 26 corporate defaults and four selective bond defaults out of 190 Mittelstand bond issues in minibond markets of Düsseldorf, Frankfurt and Stuttgart had ruined the party.
Investors or regulators would clamp down on light documentation if the Schuldschein fell under the same fate. To keep that from happening, and thereby preserve its distinctive character, arrangers and investors are determined to maintain their rigorous analysis.
“We’ve added to our credit analysis team and will only work with arrangers we’ve had long relationships with,” says a senior international investor who asked not to be named. “Investors should not rely on the good name of the Schuldschein market as a measure of issuer quality. They must recognise the fact that three quarters of issuers do not have public ratings, and be responsible.”
But the most important Schuldschein investors, unlike with minibonds, are not private people. As one investor from a German savings bank says: “we are big boys.”