As the Euro-MTN market grows deeper and wider, German investors are still caught between tradition and innovation. German fund managers have long been seduced by schuldscheine and are finding them difficult to leave behind, but MTNs are increasingly the enticing alternative. And with tax advantages for buying low-coupon notes, international sectors such as the yen market are becoming more attractive. Jon Saunders, European head of MTNs at Dresdner Bank, says: "The older, more traditional investors still turn to schuldscheine, but the younger, more dynamic investors aren't so bothered and are more willing to access the MTN market." Schuldschein trades offer more privacy than privately-placed Euro-MTNs and are tucked away from the prying eyes of the market. The documentation is less onerous for issuers too, and as they are considered a loan they are not marked to market as bonds are. But these benefits do not override the need for some investors to jump aboard the accelerating Euro-MTN bandwagon. One of these young opportunists is Metzler Asset Management (Metzler). It was founded in 1987 and every one of its clients comes from Germany. Corey Young, senior portfolio manager at Metzler, says: "We don't directly target MTNs. What drives the decision is the credit analysis, and this has nothing to do with the type of bond being used." This unspecific, product-driven approach is becoming more common among German funds, and as a result Euro-MTNs have a bigger role in their portfolios. And issuers are noticing the trend too. Kreditanstalt fur Wiederaufbau (KfW) has two Euro-MTN programmes in the market, with combined outstandings of $45.33 billion. Twenty per cent of its issuance in 1999 was through schuldscheine, according to the borrower. Frank Czichowski, head of capital markets at KfW, says: "We have seen a general decline in demand for schuldsheine, especially on the structured side, and an increase in appetite for private-placement notes. This is possibly because some of the structured products in schuldscheine have not paid off. And I also think we will see a move towards bearer securities instead of loans." Liquidity in the schuldschein market is not what it could be. But those involved refuse to accept this as a reason for investors slowly moving towards Euro-MTNs. Saunders, at Dresdner, says: "The liquidity is limited in the schuldschein market, but how liquid is the MTN market really?" And liquidity is a big factor in the investment choices of BfG Investment Fonds (BfG), which has $7 billion of assets under fixed-income management. Roger Schneider, head of fixed income at BfG, says: "In my 10 years of experience in MTNs I've found that investors are not adequately compensated for their low liquidity. The billion dollar deals are okay, but whenever we wanted to sell smaller notes in the past we've not been the only ones." Young, at Metzler, has a similar view. He says: "As an investor, liquidity is very important. We need to be able to sell the paper when we want. I wouldn't say liquidity in the MTN market is strictly limited, but the advantage is with the issuer." This has led to some investors turning to the bund market. And with the interest rate-hike by the European Central Bank on August 31 it may become even more popular. BfG intends to build the bulk of its investments around the government sector because of its good liquidity and the paper's ability to develop a nice scarcity premium. The ease with which issuers can sell structures is one possible reason for the growing acceptance of the Euro-MTN in Germany. But investors are not convinced. Structured MTN issuance in euro and Deutschmark this year is only $13.48 billion, less than half of last year's figure for the same period, according to MTNWare. Schneider, at BfG, says: "We stay away from structures as much as possible because of their poor liquidity. Structures are really nothing more than cashing-forward instruments and I'd prefer to do the same thing with different trades rather than risk it all in one deal." But dealers report growth in some areas. Henry Nevstad, director, Euro-MTNs at Deutsche Bank, says: "The particular themes of 1999 were reverse convertibles and constant maturity swap-linked (CMS) floaters. If anything can be pointed out as themes so far this year, it must be an increase in credit-linked note issuance or other credit derivative-related products. We believe these will continue to play an important role in the average German investor's portfolio going forward." And Benedicte Guerin-Cribier, deputy head of MTNs at BNP Paribas, has seen other products. She says: "It's been quite quiet recently but we have done some equity-linked and interest rate-linked deals for German investors. But I would not pick them out especially; this is something most European investors are interested in." And despite this year's fall-off, investment in structured notes has not always been considered a gamble. Nevstad, at Deutsche Bank, points to a surprising willingness on the part of German investors to take on risky trades. "If you compare German investors to the Italians then they can seem quite cautious, but compared to the Swiss it is just the opposite. You could say the German investor base is conservative overall, but it really depends on what kind of structures you look at. Ultra-long-dated callables, being done quite frequently in 1998 and 1999, are quite a hefty risk to take on," he says. Bayerische Hypo- und Vereinsbank (HypoVereinsbank) is a highly active issuer in the German markets. German investors buy over 50% of its notes. It has two Euro-MTN programmes with total outstandings of $25.26 billion and is also active in the schuldschein and Pfandbrief markets. Isaac Alonso, head of funding products and MTNs at HypoVereinsbank, says: "All in all we don¦t have the typical investor any longer. Every investor is different. And they change their minds over the year depending on their performance on interest income and their spread performance." Alonso has also seen enquiry for Euro-MTN structures this year. CMS-linked notes have been popular. But he adds: "Since March the favourites with our investors have been FRNs. This has also been the case in the past, but the sizes now are smaller. And reverse convertibles, the favourite of 1998 and 1999, are no longer on the cards - who needs high coupons any more? Instead discount certificates are being bought." This is because German investors come to the market knowing exactly what they want. Saunders, at Dresdner, says: "There are still three distinct types of German investor: the short-term, low-coupon yen buyer, the interest-rate view buyer, and the credit buyer. And Germany is still very split in its preference for credit. It's either double-A and above, or triple-B, split about 70:30." This need for highly rated borrowers means banks and government-backed issuers tend to be the preferred targets. KfW is guaranteed by the Federal Republic of Germany and is triple-A rated. Czichowski, at KfW, says: "The prime reason investors come to us is that they can invest in a zero-risk, government-backed credit. This means they can concentrate on the structure and don't have to worry about the underlying debt." The other type of investor, looking further down the credit curve, is exemplified by BfG. Schneider, at the firm, says: "We mainly concentrate on the money markets, so liquidity is not the main priority here. Instead we look for good names and credit ratings, normally having a thorough look through the single-A sector." And this interest is directed at the domestic market first. Only German borrowers issue schuldscheine. And if the right product is found in the MTN market, investors will try to place their money with a German issuer before going to another. But this could soon change. Nevstad, at Deutsche Bank, says: "Investors prefer to look at names from their domestic markets first, but a lot of them have filled their lines with certain domestic players. This, in conjunction with the introduction of the euro and a larger pan-European focus, has meant that they are more willing now to look across borders for opportunities." This is why MTNs are gradually being phased into many funds' portfolios. The MTN market has the global characteristics that allow German investors to continue buying the paper they need. And investors are more willing to mark notes to market so the benefits in the simpler schuldschein sector are no longer relevant. However, smaller investors do not appreciate the extra work involved in marking trades to market. Saunders, at Dresdner, says: "Mark-to-market rules are a very big influence, especially for the smaller investor. It is quite an onerous task and so many move toward schuldscheine instead, where they don't have to mark-to-market." The larger investors do not mind making the effort however, when it means they can keep track of their money's performance. Young, at Metzler, says: "Mutual funds have to mark-to-market every day, because people are getting in and out every day. Institutional money is marked to market on a monthly basis. We are involved in both types and find marking trades to market a very useful exercise." And schuldscheine are not always an important part of a German fund's portfolio anyway. Those with clients from a variety of countries have to be able to access different products at will. Schneider, at BfG, says: "Schuldschein represents a small part of our work because we have restrictions on how much of our portfolio can consist of non-listed products. We also have to be sure of getting a sizeable premium to give the necessary liquidity." And once in the Euro-MTN market there are ways of increasing the value of the notes. German law has a tax incentive whereby mutual funds based in Luxembourg can receive discounts if they buy low-coupon paper. This is why many German investors go to the yen sector. Operated on a ladder system, one-year notes may only be taxed at 1% for example, two-year notes at 2% and so on. Nevstad, at Deutsche Bank, says: "There is an inherent tax advantage for these investors to buy low-coupon assets, as there is a difference in the treatment of capital gains tax and income tax. The fact that there is a limited supply of these low coupon, tax-advantageous bonds from the secondary market has led to the creation of a large new-issue market for such securities over the past years." BfG is one fund that takes advantage of these benefits. Schneider, at the firm, says: "We have some tax optimising schemes in place, one of which is where we buy low-coupon currency bonds and swap them back to euro, where the profit on the currency is not taxed." But these tax exemptions are little compensation when liquidity, the most important quality, is still missing from the MTN sector. German fund managers are still reluctant to embrace it wholeheartedly. Schuldscheine have a legacy of simple success, and some issuers prefer to take this tried and tested route. Schneider is happy to keep shopping around. He says: "At the moment it's worth playing the market on a trading basis, looking for undervalued products and taking your chances."
November 17, 2000
