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Corporate BondsPrivate debt

Can the Schuldschein stay on top when rate climate changes?

The Schuldschein market attracted a record number of international issuers last year, and swept aside other forms of European private debt in the process. Now it must confront a bigger beast — a credit-hungry unrated public bond market — while simultaneously absorbing the impact of the European Central Bank winding down its bond purchasing programme. Silas Brown reports.

At first glance, the Schuldschein markets of 2016 and 2017 might not appear very different. After all, total issuance ticked up only €1bn to roughly €27bn.

But each figure was rustled up using a different recipe.

In 2016 total volume was carried by larger companies like Lufthansa, Hofer and Porsche issuing €1bn-plus loans, alongside M&A-inspired activity from companies like Groupe SEB and Mann+Hummel. 

This was not the case in 2017, when fewer large transactions took place. Rated and unrated public bond markets were more competitive on price, so the argument for the use of the Schuldschein became less persuasive. 

Kion was the only borrower to break the €1bn mark last year. But as Schuldschein investors grew more comfortable lending to smaller international borrowers, the procession of companies entering the market grew longer. 

Average deal size fell a third to €160m as roughly 150 firms raised Schuldscheine. More than two fifths were non-German.

The formula for success in 2018 will be to pluck the successful elements of both years and maintain the flow of new arrivals, while drawing the larger borrowers back. 

Tangle with bonds

But the unrated public bond market is proving a game competitor. For some issuers, the pricing it offers is more attractive than what they could get in the Schuldschein market.

French video game developer Ubisoft, which had issued €200m of five year Schuldschein notes in March 2015, sold its first corporate bond in January — a €500m five year note, priced at 85bp over mid-swaps.

This was tighter pricing than its Schuldschein, one banker in Frankfurt noted. 

Orpea, the French care homes group that is another prized convert to Schuldscheine, followed in early March, selling €400m of bonds at 200bp over mid-swaps.

Both issuers obtained substantial order books — in Ubisoft’s case over €1bn — which drove the price down to inside what they could have achieved in the Schuldschein market, one banker noted.

“Ubisoft could quite easily have issued further Schuldscheine at benchmark size,” says Richard Waddington, head of loan sales and private debt at Commerzbank in London, but accepted the product’s pricing advantage had diminished due to a hot bond market. This started to unwind in the first quarter of 2018, however.

“The unrated market is much more volatile so perhaps it makes sense for borrowers to place bonds over Schuldscheine when the conditions are strong,” says one Schuldschein banker in Frankfurt. “But we’re hoping for less strength and stability [in public bonds] over the course of the year, so we can convince corporates that there is less execution risk in private debt.”

There is evidence that this position might hold some weight.

Over 20 issuers have sold Schuldscheine so far this year and supermarket chain Rewe became the first to raise €1bn, pricing three, five, seven and 10 year fixed and floating rate notes at the tight ends of margin ranges: 50bp, 65bp, 80bp and 100bp. 

“Throughout 2017 markets were very stable,” says Kai Seeger, deputy head of UniCredit’s global syndicate. “But with more volatility you might see larger issuers using the private debt markets more frequently again.”

Telefonica Deutschland and Volkswagen Financial Services both raised over €500m in the first quarter. The former offered tenors of seven, 10, 12 and 15 years, while the latter sold a two year Schuldschein to a single investor.

“There are many European corporates with the capacity to place Schuldschein loans above €500m, with no execution risk whatsoever,” says Andreas Petrie, head of primary markets at Helaba in Frankfurt. “These issuers can treat the Schuldschein as a useful source of [investor] diversification, and can help their debt maturity profiles.” 

Some fear that if the larger borrowers return en masse, there will be less space for smaller issuers, as arrangers and investors will be drawn to the easier credit work and larger ticket sizes that go with bigger companies.  

“Who wants to go through the stress of analysing some tiny German corporate debut Schuldschein when there are blue chips on offer?” asks an international investor at a commercial bank. “It’s much more work, the smaller the company is, and there is no necessary pick-up on spread — so it is more of a strain on resources, and from our perspective larger borrowers are more cost and time-effective.”

Bankers also grumble about having to do the same work for a smaller fee when a smaller borrower comes to the market, and argue that credit analysis is harder. Some sceptical analysts believe an over-reliance on smaller, unrated companies could spell trouble further along the credit cycle.

Can small be strong?

With more unrated issuers entering the market than ever — three quarters of last year’s borrowers and four fifths of volume, according to Helaba — a fierce debate has boiled up between analysts over whether they will bring credit deterioration to the market.

Scope Ratings, a rating agency in Berlin, urged caution in January. “Investors need to be careful in assuming the high credit quality of the Schuldschein market in the past will automatically apply in the future,” it warned in a report.

Scopes believes the credit difficulties of two Schuldschein issuers in particular, Carillion and Steinhoff, illustrate a broader decline in the market. 

“It takes time for patterns to become visible,” said a director at Scope, when the report was published. “Our prediction is it will become more visible over the coming months.”

These sorts of conclusions, however, are largely met with derision across the market. 

“There may be a few niche issuers that access the market with poor quality, but it will never be the norm, as the lenders are too interested in credit quality and analysis to buy much sub-investment grade debt,” says Paul Kuhn, head of BayernLB’s debt capital markets corporate origination team in Munich.

Ulrich Kirschner, a senior credit analyst at Helaba, came to the opposite conclusion to Scope’s in a report also published in January.

“In our opinion, the sound credit metrics of unrated issuers indicate that the Schuldschein market continues to offer investors a broad range of companies with a good investment quality,” said Kirschner.

The report goes further, noting that the credit metrics of unrated borrowers are often more attractive than those of the rarer rated issuers.

“The average earnings-based leverage ratio for the group of unrated issuers was yet again below that of companies with agency ratings in 2017,” Helaba said.

“In addition, the median ratio of net debt to Ebitda of 2.0 times, or mean ratio of 2.2 times, saw a further improvement compared to the year before.”

Perhaps it is reassuring that analysts, when confronted with the same data, can disagree on it so fundamentally. 

But, whichever conclusions are correct, there would be less concern if investors felt better compensated for the risk. Even if there was no fall in credit quality, spreads fell some 20bp-30bp on average last year.

This downward cycle of spreads should change as quantitative easing subsides. There will be less pressure on margins, and risk is likely to match reward more even-handedly.

So long, ECB

The broader conversation across private debt is turning to the effects of the European Central Bank withdrawing its monthly slug of stimulus from the public bond markets. The Schuldschein market is trying to work out how the pieces of the debt puzzle will shift as a consequence.

Some lenders, in particular European commercial banks, have been forced to enter the Schuldschein market looking for yield. As margins rise again, there is concern that bank lenders in particular might move as a block back to loan or public bond markets, which would affect the margins an international issuer could achieve. 

One banker said commercial banks’ original incentive to enter the Schuldschein market had been spread, but he hoped they had become accustomed to the product. 

Alongside the traditional qualities of the Schuldschein, like low costs, lean documentation and no external rating requirements, competitive margins have drawn international borrowers to the market. 

There is a clear correlation. When ECB president Mario Draghi’s bond buying programme began in 2015 and margins fell for both private debt and the bank loan market, the Schuldschein broke its yearly issuance record, reaching €20bn. Yearly volume continued to rise as average spreads fell, as bank lenders strove to put their money to work.

This tightening trend might be reversed this year, and some banks have noticed that treasurers are aware of this.

As NordLB concludes in its outlook for 2018: “Fears of a negative trend in the currently favourable refinancing environment have, however, entered the heads of issuers since the ECB’s announcement of the implementation of its exit strategy. We assume that the necessary funding will continue to be brought forward in 2018, to secure the currently favourable conditions.”

When the ECB withdraws, and provided margins rise as a consequence, this could affect private debt markets across Europe more broadly.

So far, the markets have largely divided along lender lines, with banks gravitating towards the Schuldschein market and institutional investors using the Euro PP and US PP instruments. 

Once central banks retire from active duty and institutional lenders feel less squeezed, they could migrate more into Schuldscheine and talk of the harmonisation of European private debt markets could return.