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Europe's muni market proves slow burner

01 Mar 2000

Europe's cities and regions are drifting into international markets, rather than rushing, as Euan Hagger finds out. But some are blazing the way in attracting international interest

A Eu1bn benchmark which the German federal state, Sachsen-Anhalt, plans to raise by the end of March will cap a busy quarter for bond issuance by fellow Länder. As such, the transaction has special relevance, since Sachsen-Anhalt's borrowing strategy in the public bond markets has been driven by the notion that the dominance of Schuldscheine - semi-tradable instruments which German mortgage banks (Hypothekenbanks) lend to German federal states as collateral for part of their bond issuance (Pfandbriefe) - is under threat.

Sure enough, the greater visibility of Länder in the bond markets over recent months has been driven by weaker supply from mortgage banks of Pfandbriefe collateralised by Schuldscheine, which for Länder has meant lower demand than usual for Schuldschein product.

"There has been a 7% shift by Länder away from Schuldscheine towards more public-type transactions, which provides an indication of the changing pattern of demand within the Schuldschein market," says Wolfgang Engel, head of debt capital markets for Germany and Austria at BNP Paribas, which is acting as joint bookrunner of Sachsen-Anhalt's latest offering alongside Deutsche.

For Hypothekenbanks, the yield on Schuldscheine is so low that there is now a negative arbitrage between their Pfandbrief issuance and their Schuldschein assets. As a result, Hypothekenbanks look to maturity mismatches, swaps and derivative plays to make a positive margin. Another alternative, though, is to source higher yielding collateral from public entitities outside Germany - for instance, from sub-sovereign borrowers in markets such as Italy and Spain. That is a tactic that Hypothekenbanks have been pursuing with increasing vigour over recent years.

The Schuldschein market is in danger of losing steam, although for most German Länder it is by far and away their most important source of borrowing. The market's future is further threatened, though, by the possibility of regulatory changes, which may ultimately constrain the ability of Hypothekenbanks to make interest rate bets and other plays.

For bond houses with international franchises, the hope is that the Schuldschein market's somewhat shaky outlook will encourage a switch in borrowing strategies among the Länder towards broadly distributed bond offerings.

So perhaps the high level of new issue activity over recent months provides an indication of such a shift? Primary market volumes have been impressive, but that sadly has been the only remarkable aspect of the supply.

Between January and February, Länder issued fixed and floating rate debt totaling almost Eu2.5bn. Just under Eu1bn of that was issued in the third week of February alone.

Offerings have included a rare appearance by Schleswig-Holstein, which entered the bond markets for a Eu500m seven year floater paying Euribor less 10bp, as well as a Eu100m 4.5% two year bond from Nordrhein-Westfalen (NRW). The Land last made an appearance in December, with two Eu50m and Eu100m six year floaters paying Euribor less 6bp and 8bp respectively.

Additional offerings have included a Eu100m increase to a Eu750m six year floater from Rheinland-Pfalz, paying six-month Euribor less 0.125%, together with two Eu250m five year floaters from Land Berlin priced at Euribor less 10bp.

But although interesting from the perspective of new issue volumes - and although helping various lead managers with their league table positions - the recent supply has had little relevance for the majority of investors.

German mortgage banks could theoretically have taken up a large portion of the paper, but in most cases pricing has been too aggressive to attract their interest, let alone still broader appetite from investors. Instead, the majority of the deals have been done for the benefit of Landesbanks, which have used the paper to top up their refinancing products.

"The latest floater from Rheinland-Pfalz and the two floaters from Berlin were more or less aimed at single Landesbanks, which have probably placed the paper in their portfolios to sell under repo facilities to the European central bank," says a German debt capital markets executive.

"The floater from Schleswig-Holstein was done along similar lines. All these deals were priced 2bp to 3bp or more inside secondary market levels, which meant there was little interest among other types of investors."

In contrast to these largely self-referential borrrowing exercises, participants claim the Eu1bn bond which Sachsen-Anhalt is soon to raise may be a transaction of real note.

Triple-A rated Land Hesse, which issued a Eu1bn bond last year, is the only other German federal state to be pursuing a institutionally targeted international borrowing strategy through the public bond markets.

But Sachsen-Anhalt, which is rated Aa3/AA-, has gone the farthest with its strategy. A DM2bn benchmark was raised by the former east German state in 1998, which was followed by a Eu1bn transaction last year.

For the current benchmark offering, Sachsen-Anhalt is using a global format for the first time.

"We expect activity in the Schuldschein market to decrease over the next couple of years and so our strategy has been to build up a following among international investors by issuing large, liquid bonds," says Sachsen-Anhalt's treasurer, Axel Guehl, who was roadshowing in Asia at the end of February.

"After we have completed the Eu1bn transaction, we will consider the possibility of increasing the issue in April. Originally we wanted to do two deals in euros and dollars, but an increase to the euro transaction may well be the best way forward," he adds.

A dollar offering totaling $650m was initially discussed, but demand out of the US for German sub-sovereign bonds remains limited.

If Sachsen-Anhalt returns to the market after its first outing this year, the borrower may attempt to tap into strong demand from Japan. For the present offering, European investors are likely to provide the strongest bid.

"The largest investor base in Asia for this type of transaction is Tokyo, but feedback indicates that until the end of the current fiscal year, which is the end of March, there is unlikely to be a huge amount of demand," says Adolf Bothe, head of debt capital markets origination at Deutsche Bank, Frankfurt, which is acting as joint bookrunner of the current transaction alongside BNP Paribas.

"Once investors have set out their investment policies for the new fiscal year, though, there is likely to be good interest for paper. Sachsen-Anhalt has a strong following among Asian investors and although the euro has been weak against the dollar, investors in Asia may feel that now is the time to try and capture the low point in the cycle."

Bothe at Deutsche is not the only banker to have Asian demand in his sights. "Asian investors are starting to feel that perhaps their allocation to euro is too small, although they have not necessarily changed their view entirely that the euro has bottomed out," adds Engel at BNP Paribas. "Nonetheless, now may be a good point at which to get back into the market. Sachsen-Anhalt is a welcome issuer in Asia. It has been in touch regularly with investors in addition to making roadshows in successive recent years,"

The major sources of demand in Japan for Sachsen-Anhalt paper are life insurance companies and trust banks, together with some of the big money centres. Financial institutions in Singapore and Hong Kong seeking liquid, shorter dated investments, together with the central banks in those two markets, are further sources of potential demand.

In Europe, Sachsen-Anhalt will be hoping to attract a strong bid from international buyers of German Pfandbriefe that are looking for diversification. "Diversifying into direct state assets could look attractive, particularly if investors are heavily invested in the Pfandbrief market," says Deutsche's Bothe.

European buyers of past international offerings have included large Scandinavian pension funds, as well as fund managers of retail money in Switzerland and Italy. Reflecting the presence of BNP Paribas as joint bookrunner, the current deal is likely to involve a longer dated maturity, with a view to attracting demand from French insurance companies.

The roadshow in Europe has included visits to London, Scandinavia, France, Italy, Spain, and Switzerland.

Although offering internationally distributed bonds entails raising money at wider spreads compared to Schuldscheine, the exercise sidesteps all the loose ends that need to be tied together when raising funds in small amounts. "Funding can be put in place that might take months to complete in the Schuldscheine market. In that market, it is not going to be as easy as it has been in the past to do transactions whenever one wants. With internationally targeted bond issues, on the other hand, one can take advantage of good moments in the capital markets to put away transactions in significant size," says Sachsen-Anhalt's Guehl.

Whether other German federal states besides Land Hesse will heed such arguments is for now debatable.

"There is a need for German states to come more and more to the international bond market alongside other European sub-sovereign peers, but for the time being the pricing argument for issuing Schuldscheine is a powerful one for most Länder," says Engel at BNP Paribas.

For now, therefore, borrowers from other countries provide the greatest prospects for international issuance by European sub-sovereigns in terms of numbers, if not new issue volumes.

Germany's Hypothekenbanks are the main destination point for paper issued by non-German sub-sovereigns, although demand from other types of investor is growing. "There is interest around Europe from life insurers because sub-sovereigns tend to issue in longer dated maturities," says a fixed income syndicate manager at Warburg Dillon Read, adding: "Although these sorts of account are by no means the tightest bid in the market. There is growing demand, too, from Asia, which partly reflects greater interest in quasi-government issuers due to the declining trend in government issuance within Europe. Central banks in Asia are beginning to play a more important role in the market, as are some of the large Asian funds, which are looking to diversify their portfolios away from US dollar-denominated paper,"

An offering which Warburg lead managed for the Italian region of Lazio, in January, is a case in point. Over three quarters of the Eu250m offering of 15 year notes, priced at the equivalent of 18bp over Euribor, was sold into Asian accounts.

"The extent of the demand from Asia was a little unexpected, but it illustrates the increasing appetite within the region for European sub-sovereign paper," the Warburg official said.

Issuance by Italian regions and municipalities is relatively sporadic - and is likely to remain so - but the Lazio deal and an offering from the region of Umbria, last December, have kept the clock ticking over.

Umbria's Eu602m 19 year transaction, which was priced at six month Euribor plus 20bp, was the first of up to four instalments which the issuer can draw on under a Euro-MTN facility underwritten by Chase Manhattan, DePfa Bank Europe and Dexia Capital Markets-Crediop. The funding is going towards reconstruction works, following the earthquake which hit the region in 1997.

Up to Eu2.6bn can be issued off the programme by the end of 2001, the same figure as the present value of the reconstruction funds received so far by the region from central government.

The debt issuance programme is unusual, since it includes an embedded option which places a cap on the spread over Euribor at which the issuer borrows. The cap was set at Euribor plus 20bp. The device has left some bankers feeling puzzled. "Unless there is more to this meets the eye, it is difficult to see how the option will really benefit the borrower. Euribor might go up, but there is no special reason for supposing that the spread over Euribor for Italian regions will fluctuate by much. If the borrower could issue at a fixed price plus 20bp, then clearly it would be an option with a value," says an investment banker at a US bond house.

Arrangers of the debt issuance programme were unavailable for comment.

Although further deals are in the pipeline from Italian sub-sovereigns - including a $650m equivalent issue for an unnamed borrower which has been mandated to Merrill Lynch - the pace of supply from regions and municipalities will remain sedate.

That said, securitisations may add some spice to this year's supply. Lazio is looking at securitising cashflows from local health agencies via a Merrill Lynch-led deal, and Sicily is also considering a securitisation based on a wide range of cashflows.

In addition to these structured financing possibilities, bond offerings will come on a piecemeal basis.

At the municipal level, although responsibilities are being transferred from central government as part of the decentralization that is underway in Italy, local authorities are assuming the role of co-ordinating entities. The investment function will thus fall to the companies which end up running local authority services, rather than to the municipalities themselves.

As with much of the bond issuance by the regions, municipalities have looked to the bond markets for the cachet that is conferred, rather than for specific funding needs. In the case of the regions, the need to meet deficits in healthcare budgets has created a funding need, but most regional authorities that have tapped the bond markets could just as easily have gone to their bank lenders.

The need to cover healthcare budget deficits is in any case diminishing. "In 1996 and 1997, imbalances within healthcare budgets were at their most severe, but deficits are disappearing relatively fast," says Philip Moschetti, analyst at rating agency Fitch IBCA.

Although the visibility that goes with an international bond offering will remain the primary motive for issuance, some regions - Sicily among them - have had more concrete reasons for wanting to tap the bond markets.

Two to three years ago, Sicily was virtually debt free, but that changed when the Italian government began to eye the region's tax revenues in the run-up to entry into Emu. Unlike many of its counterparts in Italy, Sicily is an independent region which until recently was beneficiary of all the tax revenues collected by central government within its border. But as part of the Italian government's rebalancing of its own accounts in preparation for Emu, tax revenues from Sicily were considered fair game.

Sicily's budget had until then had been in a delicate equilibrium, but subsequently it ended up catastrophically out of kilter. So much so that the region's initial entry into the bond markets followed on from two failed attempts to work with its bank lenders.

The offering which is due to appear this year is expected to be roughly $650m in size, and follows on from a $1bn issue raised via Merrill Lynch in 1999. That offering consisted of a mixture of Schuldscheine, fixed rate and floating rate notes.

Sicily's story is unique, and among European sub-sovereigns, its reasons for tapping the bond markets are uncommon.

As in Italy, issuers in markets such as France and Spain will continue to do so at least partly for reasons of prestige. *

01 Mar 2000