Although most German states raise their debt domestically, either through the Schuldschein market as or joint Länder transactions, more and more are following the lead of Saxony-Anhalt and tapping the international capital markets, offering investors quasi-government exposure at a spread to the Bunds. But even as the number of broad minded Länder increases, the future existence of public bonds that they issue is being debated.
Over the last two to three years, Axel Guehl has reportedly moulded himself into something of a brand name in Tokyo. He has not done a bad job in the Middle East, either, which was precisely where he found himself at the time of the terrorist attacks on New York and Washington in September. The treasurer of the ministry of finance of Saxony-Anhalt, together with his lead managers, was flying from Saudi Arabia to Kuwait roadshowing the German state's most recent benchmark transaction when the news broke of the tragedy in the US.
Shocked though the delegation and its hosts were by the news from the US, Saxony-Anhalt's roadshow to the Middle East was demonstrably a success, and helped Guehl in his tireless pursuit of investor diversification for his benchmark bond issues. In the most recent case, this was a five year Eu1bn issue led by BNP Paribas and Dresdner Kleinwort Wasserstein, which was priced at 40bp over the Bobl and attracted total demand of some Eu1.75bn.
To Wolfgang Engel, head of European debt capital markets at BNP Paribas in London, the strong demand generated for Saxony-Anhalt's recent benchmark was, once again, just reward for the enthusiasm with which Guehl and his team have marketed each transaction since the state risked making itself something of a pariah among its German counterparts by tapping the international capital market.
About 45% of the bonds were ultimately placed outside Germany, with the 8% placed in the Middle East among investors new to the Saxony-Anhalt name ranking alongside the 8% allocated to institutions in the UK as the second most important non-domestic placement region. "The Middle East has tended to be neglected in terms of roadshowing," says Engel.
"But we all know that Middle Eastern institutions have net funds, and if you show the willingness to visit them in person they are very willing to listen - especially when you are talking about a name like Saxony-Anhalt that effectively offers quasi-German government exposure at a spread to Bunds. The challenge in the Middle East is that most of the investors there are dollar-based, but they are nevertheless now looking much more favourably at the euro."
Going the extra mile and spending the best part of a week cultivating Middle Eastern institutions - in addition to the Asia Pacific and European accounts that Guehl has already visited time and again - was one of the decisive factors in stoking outstanding international demand for the most recent Saxony-Anhalt benchmark. "I would say this was one of the most widely placed of any German sub-sovereign issue to date," says Engel.
Saxony-Anhalt is no longer the black sheep of the German Länder in the international capital markets, and has been joined by a cluster of other, much larger borrowers that are now intent on winning friends and influencing people within the global investor community.
This was clear when Nordrhein-Westfalen launched its first internationally targeted benchmark transaction, a Eu2bn 10 year offering via Deutsche Bank, Goldman Sachs and WestLB in March. Energetic premarketing of this deal, which involved a roadshow in which the state's finance minister personally participated, was rewarded with Deutsche Bank reporting that it placed more than 50% of its bonds outside Germany - compared with between 10% and 20% in previous deals for the same borrower.
Other landmark deals from the Länder this year have included the Eu1bn benchmark led in April by Dresdner Kleinwort Wasserstein and HSBC for Berlin. This was the largest transaction the state had ever launched, although as an unrated issue its appeal to international institutions was inevitably limited.
More recently still, at the start of October, Brandenburg jumped on to the bandwagon with the announcement of a Eu500m five year offering as part of a new international liquid benchmark programme.
And there are plenty more deals in the pipeline. In the same week that Brandenburg launched its issue, for instance, the triple-A rated Hesse unveiled a Eu2bn benchmark issue via Dresdner Kleinwort Wasserstein, Landesbank Hessen-Thüringen and Morgan Stanley, while Nordrhein-Westfalen has also signalled that it has another Eu2bn benchmark transaction earmarked for launch.
So why this change of heart among Germany's Länder? Engel puts it down principally to dwindling demand for sub-sovereign Schuldschein issues from heavyweight local investors, in particular from the German mortgage banks, which has cut off a very substantial chunk of the traditional financing options available to the states. At the same time, he points out, the loan books of some domestic banks, which in many cases are being sized down, are already highly exposed to the regional borrowers. The result is that the domestic bid for Länder issues is diminishing with alarming speed.
"Nordrhein-Westfalen was always very pragmatic about funding," says Engel. "It always recognised that as long as the domestic bid remained strong there was no point in spending the time and money on tapping international markets.
"But with the largest funding among the Länder (of more than Eu10bn a year) it now recognises that it cannot rely on this domestic bid indefinitely. Hence the speed with which Nordrhein-Westfalen secured a rating, set up an MTN programme, and put everything in place to allow it to tap the international capital markets."
None of this, says Engel, should be taken to mean that the Länder have suddenly become highly profligate borrowers for whom the cost of funding is no longer relevant. Cost certainly does matter, he says, and if the all-in costs of funding via a Schuldschein market that was a bottomless pit remained sharply lower than in the public market, Länder like Nordrhein Westfalia and Hesse would assuredly not have looked to the international capital markets with such favour.
But Engel says that the more forward-looking Länder are now becoming much more sophisticated in terms of analysing the all-in costs of present and future borrowings, and are concluding that the international capital markets is looking increasingly attractive on this basis.
At a simple level, some Länder acknowledge that there is little sense in comparing the costs of a 10 year public benchmark deal with a Schuldschein of a similar maturity, when the public bond can raise Eu2bn and the Schuldschein little more than Eu50m-Eu100m.
At a more complex level, says Engel, they recognise that the all-in costs of structured transactions off an EMTN programme twinned with public benchmark issuance are where overall borrowing costs can be driven down. "The arguments that we used to hear in the past, which is that public bond issues are a waste of taxpayers' money, generally came from those Länder that were unable or unwilling to evaluate the market for highly structured products," says Engel.
Domestic mainstream market
For the time being, progressive borrowers such as Saxony-Anhalt, Nordrhein- Westfalen and Hesse remain in the minority in terms of their readiness to tap the international capital market. For many of the Länder, the preference is still to raise funding either via the Schuldschein market on an individual basis, or to pool resources in the form of the joint-Länder transactions that have been part of the landscape since the launch of the first of these issues (Länder No 1) in August 1996.
The most recent of these deals has brought the number of joint transactions to 11, although none have been especially popular with overseas investors. Unrated, aggressively priced and seldom very actively marketed, the joint issues have been tailored largely to a domestic audience comfortable with the structure.
At Morgan Stanley in Frankfurt, executive director of debt capital markets Frank Rühland says that he detects similarities between the attitudes of Länder borrowers today and those of some of the mortgage banks in the early days of the jumbo Pfandbrief market. "Rather like in the jumbo market in 1997, the Länder tend to fall into two camps," he says.
"In the Pfandbrief market, we saw issuers like DePfa, Eurohypo, Rheinhyp and others acknowledging at an early stage that there was some value associated with widening the investor base, and those issuers were generally prepared to spend a few more basis points in order to do so. We are seeing a similar process developing among the Länder, where borrowers like Saxony-Anhalt, Nordrhein-Westfalen and Hesse are prepared to go through the international bookbuilding process, whereas others are still very cost conscious and try to squeeze out the last basis point. But over the long run I firmly believe that those borrowers taking the more balanced approach towards the international market will be rewarded for their efforts."
Others believe that as the benefits of tapping the broader international market become more apparent, more Länder will follow the Saxony-Anhalt template. And it is not just the borrowing strategies of the more forward-thinking Länder that are supporting the development of the German sub-sovereign market.
A further step towards the internationalisation and development of the Länder bond market as an asset class came in September, with the launch by electronic trading platform MTS Germany of a new segment for trading of Länder bonds. Officially announced on September 10, the news was understandably overshadowed by other events. Nevertheless, the support of 12 market makers committed to quoting continuous two-way prices for the more liquid Länder issues can only be positive for the long term development of the market.
Looking to the much longer term, the very existence of public bonds issued by the Länder is a topic that has excited political debate in Germany. The discussion centres on whether Germany should follow in the footsteps of Austria, and relieve its federal regions of responsibility for fundraising altogether, bringing all their treasury activities under one, Frankfurt-based roof.
In turn, this would bolster the overall size of the German government bond market, with Thorsten Polleit, an economist at Barclays Capital in Frankfurt, pointing out that the west German Länder have total outstanding debt of some Eu286bn, with those in the former East Germany carrying an additional Eu56bn. "That is quite a chunky amount and would be very beneficial to liquidity of the Bund market, which itself accounts for about Eu700bn," he says.
Polleit expects some form of consolidation of the government and Länder bond markets going forward. "You will find many people in the market who say this is unlikely to happen, but I am increasingly of the belief that it will materialise because of the severity of Germany's fiscal problems," he says.
"Politicians are having to search for cost savings wherever they can and it would obviously be much easier for them to reduce interest rate costs than to cut social spending."
As Polleit himself acknowledges, not everyone in the market supports his view. At Deutsche Bank in Frankfurt, managing director of debt capital markets Walter Henniges points out that the comparison with Austria is less relevant than people outside Germany might assume, because the Austrian regions have historically been much less influential or autonomous in their decision making than the German Länder.
This is especially true if the Austrian regions are compared to economic powerhouses such as Bavaria (which is no longer a net borrower) or Baden-Württemberg, neither of which, say many analysts, would countenance surrendering the autonomy of their treasury operations to an entity sitting in the relatively distant environs of Frankfurt.
Engel at BNP Paribas is also doubtful that centralisation of the Länder treasury operations would receive much support from any but the very weakest regions. "If the Länder were to stop their own borrowing and have it all channelled via the new funding agency, it would certainly save the taxpayer whatever kind of spread over Bunds the Länder have to pay," he says.
"The question is: would it be desirable? I'm not sure that it would be, given the amount of expertise that the individual Länder have as borrowers on behalf of their own municipalities and for other public sector entities within their territory." *