The performance of Germany's states
in the international markets has been patchy, to put it mildly.
Although some individual states have won plaudits for their
strategies and attitudes, the pooling of the debt of several other
states has not been popular.
Several states take the view that cheap funding is available in the local market, and that it is politically unacceptable to pay more than is necessary.
But bankers argue that all the states will eventually need to fund themselves in the international market, and that those which have established themselves early will be best placed to survive and prosper in a growing and increasingly competitive European municipal financing market.
Historically, German states (Länder) have been modest borrowers in the capital market. A Deutsche Bank report published last year points out: "The Länder's use of the bond markets is underdeveloped at 20% of total debt outstanding. Funding via banks in [the] form of Schuldscheine clearly dominates. This is in stark contrast to the funding habits of the federal government which raises about 95% of its funding requirement via the capital markets."
In recent years, Länder have been making increased use of the capital market, but not, generally, in a fashion which has endeared them to investors or investment bankers. The template which has been used most often have seen a number of the financially weaker Länder pool their borrowings into so-called jumbo issues, which more often than not has left the issuers at loggerheads with investors and several investment banks.
The sticking point has been the pricing, with the Länder in question insisting that as they are backed by the federal government and by Germany's system of redistribution of revenues among states - Finanzausgleich - they should be seen, and priced, as triple-A credits.
Investors have tended to take a different view, arguing that these are unrated issues which can only be viewed as enjoying a creditworthiness which is on a par with that of the weakest issuer within the group.
The latest in this series came in March 1999 with the launch of Länder No 6, which was a Eu750m 10 year at 27bp over via ABN Amro, Commerzbank, DG Bank and West LB. The five which pooled their borrowings on this occasion were Berlin, Bremen, Hamburg, Mecklenburg-Vorpommern and Schleswig-Holstein.
Many German Länder have long resisted the notion that they should start to establish strategic international benchmarks principally because they have a political obligation to fund themselves at the lowest possible cost, which they have historically been able to do through the immense local public sector Schuldschein market.
At the end of 1997 this was worth just under DM900bn, with Länder borrowers accounting for DM471bn (or 52.5%) of the total. The Deutsche Bank report explains: "Besides being a cheap funding source, Schuldscheine have the advantage of being individually tailored, requiring little documentation, and being issuable at short notice."
Perhaps, but bankers detect that the Schuldschein market is starting to lose some of its lustre for issuers within the German capital market.
"The reality is that the domestic market is more and more competitive for the German states," says Martin Keutner, executive director of debt capital markets at Warburg Dillon Read in London.
"This is something we hear not just from some of the German states, but also from government institutions and other issuers in the domestic market who are telling us that the market is getting more and more difficult in terms of depth and cost."
A handful of the more forward-looking Länder have responded to this by paying up to tap international markets. Hesse, for instance, launched a Eu1bn July 2009 benchmark this summer which was widely acknowledged as a blow-out success. Rated triple-A and priced at 28bp over Bunds, this was led by Deutsche Bank and Warburg Dillon Read.
Another recent Land issuer in the international capital market, which has won great acclaim for its approach to overseas institutions, is Sachsen-Anhalt.
The Land has chalked up a number of firsts among German states in recent years: aside from being the first to have a rating from both Moody's (Aa3) and Standard & Poor's (AA-) it was also the first to launch a CP programme (in 1997) and an MTN programme (in 1998), on the back of which it issued a benchmark DM2bn issue targeted at European and Asian accounts in July 1998.
In total, according to its website (again an unusual initiative for a German state), Sachsen-Anhalt has issued some 28 times off its MTN programme, and has gross borrowing requirements in 1999 of Eu2.7bn.
Eu1bn of this was raised in August in a seven year transaction led by Deutsche Bank and Warburg Dillon Read which was priced at a 33bp spread to Bunds.
The transaction was roadshowed intensively in June and July both among investors with which the borrower had already established contacts - in core Europe as well as in Japan, Hong Kong and Singapore - and in a number of regions which it was aiming to tap for the first time, such as Spain, Scandinavia and Switzerland.
"The distribution and performance of the transaction made it clear that the extra effort the borrower put into marketing the issue was clearly worthwhile," says Keutner. "In Asia the reward was very small this time around, but that was down to market reasons.
"Investors had seen the euro declining for the previous six months during which they were still buying paper and averaging their currency positions. However, it had become clear by the beginning of July that these accounts were not looking to further increase their euro denominated portfolios."
In the event, about two thirds of the Sachsen-Anhalt offering went to accounts in Germany, with the balance taken up in Austria, Japan, Switzerland, Scandinavia, Benelux and France.
Keutner says that in the circumstances the participation of Japanese investors was important. "Japan accounted for a small take-up," he says. "Nevertheless, Japanese demand was there which was an encouraging element. It was the icing on the cake that some sales were made in an adverse environment into Japan."
Another highly encouraging element of the issue, says Keutner, was the strength of demand from Swiss accounts. "Bear in mind that the Swiss investor base is one which more typically favours strong double-A and triple-A names," he says.
"But I think the following in Switzerland illustrated that Swiss investors perceive Sachsen-Anhalt more as quasi-German government risk than as a AA- issuer.
"The reason it is rated Aa3/AA- is because it does not have the explicit guarantee of the federal republic."
The distribution of the Sachsen-Anhalt offering aside, Keutner says that the most obvious barometer of the deal's success was in its aftermarket performance. Deutsche Ausgleichsbank (DtA), he says, issued in euros shortly after Sachsen-Anhalt at a spread of 29bp, or four basis points inside the Sachsen-Anhalt bond.
"With both transactions performing nicely in the aftermarket, Sachsen-Anhalt managed to trade down to 27bp over, similar to DtA.
"I think this demonstrates how successfully Sachsen-Anhalt has positioned itself as a credit and is catching up on the credit curve," says Keutner.
"Of course there was great scarcity value attached to the Sachsen-Anhalt issue, but then you could also argue that DtA is scarce, for instance, relative to KfW."
Looking to the future there is a division of opinion as to whether the benchmarks established by the Länder which have issued internationally are likely to open the floodgates for others.
"We feel that the Länder will be bigger issuers," says Craig Weakley, head of debt capital markets at Merrill Lynch in Frankfurt, "largely because of the pressures they will be under in terms of budget management from the federal government."
"Most of the larger ones have been watching what Sachsen-Anhalt and Hesse have done and are considering their options," says Anke Richter, associate director of credit research at Deutsche Bank in London, who adds that the most compelling potential issuer in the market is North-Rhine Westphalia, which has a population of 18m and an annual borrowing requirement of DM20bn.
Keutner at Warburg Dillon Read is also certain that other Länder will look very closely at the templates established by Hessen and Sachsen-Anhalt.
"I am convinced that step by step the majority of German Länder will appreciate and realise the relevance of these markets to their financing and therefore will carry the burden involved in the process of establishing themselves internationally," he says.
"They will embark on applying for ratings, will embark on establishing MTN programmes and will also increasingly use the international markets for larger size financings. And I believe that over time further integration between the domestic and international markets will lead to a balancing of the terms between these markets available to the German Länder. That will ultimately prove that it all makes a lot of sense for Sachsen-Anhalt, Hessen and those still to come."
Others are less confident. "At the end of the day most of the German states are very pragmatic," says one Frankfurt-based banker. "They look at the cost benefit and as long as there's no cost benefit from diversifying they stick to their traditional funding sources.
"They are very aware that tapping international markets for the first time would involve paying an entry premium which is not politically very acceptable for most German states."
Another banker is more forthright in his prognosis of likely attitudes of German Länder towards the international market. "Some of them have bought the marketing argument that they are now competing on a European level with Spanish provinces and with French departments," he says.
"As a result they're going overseas and paying one or two basis points more than they would in the Schuldschein market to get international placement.
"I frankly think that may be a mistake because what happens is that if you have international placement all the bonds flow back if they are one or two basis points cheaper than the ones in the domestic market."
The cost differential between local and international markets aside, some bankers also point out that there is a simple logistics benefit for Länder relying on the local market.
"The likes of KfW and EIB have predictable cashflows and funding requirements," says one banker, "whereas tax collection at the Länder may come in much higher or lower than forecast. That means their longer term funding requirements are much more difficult to quantify."