Imagine a form of debt that can be issued by almost any borrower, from anywhere in the world, an instrument that regulators cant insist is marked-to-market and that can be sold far from the prying eyes of competitors in a market that is never closed. You would expect such a product to be popular, and its no surprise that Schuldschein proclaimed by supporters to offer all these benefits has experienced a surge of interest this year.
Led by the likes of BMW, Siemens and Vodafone, blue-chip corporate borrowers have been the most high profile users of the Schuldschein market. Theyve spearheaded its evolution, turning it from a private placement business into one capable of absorbing benchmark sized transactions. And as its grown in stature, the product has deepened its appeal to international issuers and investors beyond its German roots.
Formally known as Schuldscheindarlehen, it is a loan agreement or certificate of indebtedness and is usually translated as a German promissory note. The loans are characterised by simple and informal documentation, which is possible because they are embedded in the German civil code.
German public sector issuers such as federal and regional states as well as municipalities and German banks have historically dominated the market. For close to a decade, unrated small and medium sized enterprises from the German Mittelstand and a few German investment grade corporate borrowers have made up a large portion of issuance.
"It is traditionally a German instrument, so for German companies it was always an interesting instrument to fund smaller amounts on a quiet basis," says Dominik Buric, director of corporate origination at LBBW in Stuttgart. "Its nothing new really for a German company."
That changed this year. With investors hungry to buy corporate credit, but borrowers deterred from the public bond market by volatility and bond spreads stretched to levels wider than borrowers wanted to pay in public, large corporate issuers began investigating the Schuldschein market.
Deutsche Telekom sold an Eu800m six year Schuldschein in January. Then in April the borrower raised another Eu180m with a seven year deal, while E.On completed a Eu650m seven year and German retail group Metro also tapped the market with a Eu500m four year.
BMW changes the game
But it was BMWs Eu1.35bn deal launched in April that really drew attention to the market. The five year issue is the biggest transaction in the market to date.
BMW achieved pricing on the issue substantially lower than its credit default swap spread, and what a funding executive at the borrower in Munich described as well below what it would have had to have paid in the public bond market.
"The Schuldscheindarlehen gave us the right instrument at the right time to raise funds at attractive rates with investors which we wouldnt usually tap into with a benchmark bond," says Erich Ebner von Eschenbach, group treasurer at BMW.
However, it is difficult to be certain how much BMW saved, as its five year CDS in April narrowed from about 95bp to about 50bp. The Schuldschein paid 75bp, and three weeks later the borrower sold a Eu1.75bn seven year bond at 70bp.
The recent book-built Schuldschein deals have had a three week launch period. That means that what seems like a good deal at first may turn out to be disappointing, as bond spreads may have tightened by the time the Schuldschein is complete.
A similar story to BMWs narrowing credit spreads during bookbuilding also clouds discussion of pricing on another recent, high profile deal.
Siemens launched a deal split into five year and seven year tranches at the beginning of May. The borrower was looking for at least Eu500m, but ended up getting Eu1.1bn and pricing at the tight end of its guidance.
Siemens five year CDS narrowed from about 60bp to about 45bp during May, from a high of 122bp in March. The five year tranche of the Schuldschein was priced at 55bp, with the seven year at 70bp. The tranches were talked at 55bp-75bp and 70bp-90bp respectively.
"I cant understand why a borrower like Siemens would issue in the Schuldschein market," said a head of corporate syndicate shortly after the deal was announced. "They are out there and in the meantime the market has rallied and they could print a multi-billion deal in the public market well inside those levels. It shows the ridiculousness of this market. Now that the public market is on fire, Siemens are left as a white elephant because they have agreed to issue at wide spreads. They havent been in the market for years and their only outstanding issue is a 2011 maturity done in 2001."
However, new issue premiums over secondary bonds and CDS have varied considerably for borrowers in the public markets this year, and a 25bp pick-up on CDS has not been uncommon. Judged by that yardstick, Siemens could well have saved as much as 10bp-15bp by taking the Schuldschein route and in pricing the Eu1bn six year part of a three tranche deal in early June at the same 70bp as its seven year Schuldschein appears to justify its approach.
The other tranches of the bond issue comprised a Eu1.2bn three year tranche paying 48bp over mid-swaps and a Eu1.2bn 10 year tranche paying 85bp.
If spreads in other markets, including corporate bonds, continue to tighten, the attractiveness of Schuldschein is likely to diminish.
"My guess is when the bond markets return to more normalised levels and more reasonable pricing, the Schuldschein market will also be affected in terms of the more normalised levels," says Markus Leitner, director in Fitchs European industrials team in Frankfurt. "I dont see the current volume as sustainable. I think it will continue to exist in parallel and have some investors, but probably not in this magnitude."
But pricing is not the only reason for borrowers to tap the Schuldschein market. Issuers also enjoy the simplicity of documentation and the confidentiality of the market.
"Its an old fashioned instrument, but under these volatile market conditions its the right product," says Jörg Senger, head of debt capital markets and funding at BayernLB in Munich. "Its not a bilateral loan, but its not an exchange-listed instrument either, so its not so visible for other issuers, which is very attractive."
The fact that the instrument allows issuers access to a new investor base means that, while issuance is unlikely to remain at the current levels, it is likely that borrowers will want to keep tapping the market and issuance volumes are likely to be higher than at other times in the past.
"Its not only hype in the current market circumstances, its also a funding idea that will be maintained," says Christoph Zender, head of corporate origination at LBBW in Stuttgart. "There is a new base of investors as we saw with the BMW deal, and therefore the Schuldscheindarlehen will be an additional funding source for companies in the future."
While credit remains volatile, investors will also continue to favour the product, say analysts.
"The main reason its so popular with investors is that they have the advantage that its not mark-to-market, and I think in this kind of environment its very nice to have that," says Sven Kreitmar, co-head of corporate credit research at UniCredit in Munich.
Many bankers believe that the increased investor interest is more than just a temporary blip and see signs of the new investor base putting down roots.
"We know that new funds have been set up specifically for Schuldschein and we know that investors are recruiting people to look at opportunities in Schuldschein business," says Paul Jones, executive director of MTN trading at UBS in London. "This suggests that some investors think this business is a bit more long term. Its early days to know whether this is extra new money or its been taken out of the system of public bonds for good."
Others agree that more players are likely to enter the market."The investor base will probably continue to broaden in the next couple of months," says Buric. "Today we have several European investors who play a big part in this market and with news about the market and how attractive it is to invest in Schuldscheine, the investor base will broaden further."
Banks expand Schuldschein options
Corporate issuers arent the only borrowers to have rediscovered the Schuldschein market: financials, too, have been getting in the act. Though many have been an integral part of the market for some time, borrowers have embraced increased demand from investors for non mark-to-market debt at a time when they have had few alternatives in the primary Eurobond markets.
"More and more bank issuers, especially non-German bank issuers, are trying to tap the German investor base by issuing Schuldschein," says Amaury Gossé, head of MTNs at Commerzbank in London. "Its a way for them to diversify the investor base and to get some funding done."
German insurance companies have enormous appetite for long-dated debt products but typical bank Schuldschein issues have a legal form which dictates that they are callable after 10 years, all but preventing issues longer than this date.
Neatly side-stepping this problem is another German curiosity, the Namensschuldverschreibung a registered version of its Schuldschein cousin. As a registered product, it doesnt come with a 10 year call.
International financial issuers including Intesa SanPaolo and SNS Bank have recently begun using the instrument to access German investors.
"We see some appetite and first issued at the beginning of this year and have recently closed another" says Rene Genet, a funding official at SNS Bank in Amsterdam. "So thats positive and hopefully this trend will continue."
Another tool being used by international bank issuers is the Namenspfrandbrief, which as its name suggests, is a registered version of the traditional Pfrandbrief instrument. Like Schuldscheine, Namenspfandbriefe are classified as loans and receivables, and thus also require no mark to market valuation under German law.
"Once again its not a new instrument, but for the reasons of name diversification and desire for more spread, German investors have been looking outside of Germany and over the past year or so more and more non-German issuers are setting up registered covered bond documentation," says Gossé.
The French obligations foncières issuers Dexia Municipal Agency and Compagnie de Financement Foncier were among the first international borrowers to access the product after they put in place documentation at the end of 2006 and the beginning of 2007 in order to find an alternative as demand for their structured EMTNs declined. Others were watching closely, and, in the aftermath of the credit crisis many more have followed. DnB Nor, Caja Madrid and ING are all said to be active issuing the product.
Public sector borrowers have also decided to take advantage of the current appetite for Schuldscheine. Though the German federal states had been doing as much as 55% of their borrowing through the Schuldschein market they were gradually moving away from the market, says Valentina Stadler, a senior credit analyst at UniCredit. That changed when the credit crisis hit.
"Before the subprime crisis among public sector borrowers we had a shift away from Schuldschein loans towards bond issuance and liquid tradeable issuance of a large size," notes Stadler. "Now in the more difficult market environment theres been a rediscovery of the Schuldschein as a funding instrument."
The bulk of issuance remains plain vanilla, she says, but structured deals are also common.
Public sector issuers from outside of Germany are also watching the Schuldschein market with interest the Spanish autonomous communities of Valencia and Castilla y Léon, the Nordic Investment Bank and the Finnish Municipality Finance are all among recent entrants to the Schuldscheine club.Theyre unlikely to be the only ones.