DOMESTIC BONDS

GERMANY

A EUROMONEY SURVEY – June 1996

Prepared by Helmut Kaiser, Head of Fixed-Income Research, Frankfurt, and Werner Krämer, Senior Analyst,

Deutsche Morgan Grenfell
Measured in terms of the nominal amount of bonds outstanding, the German bond market ranks third in the world after the US and Japanese markets (see Chart 1: year-end 1994 data). In terms of net sales of fixed-interest securities, it has been the second largest market since 1992 by international standards. In Europe, the German bond market, with a turnover of Dm2.870 billion at year-end 1995, occupies the leading position. The total volume of Deutschmark bonds outstanding has roughly doubled compared with 1990.

Market segments and issuers

In terms of turnover, bank bonds play a leading role in the German bond market (49% share in 1995), ranking above public sector issues (38.5% share in 1995). Deutschmark-denominated Eurobonds accounted for 12% of issuance while corporate bonds play only a minor role in the German bond market, accounting for less than 1% of issuance in 1995.

The public sector, as a group of issuers, comprises the following agencies:

* The Federal government and its special funds, accounting for 56.6% and 10.4% of public-sector debt respectively;

* the Treuhand agency (which ceased to exist at the end of 1994), accounting for 12.7% of public-sector debt;

* the Länder governments, or federal states, accounting for 9.6% of public sector debt; and

* the rail and postal services, accounting for 10.7% of public-sector debt.

The securities falling under the generic term of bank bonds comprise mortgage bonds, communal bonds and other bank bonds issued by mortgage banks, Landesbanks, credit institutions with special functions, and commercial banks. The market for foreign Deutschmark bonds is used by public and private issuers. Foreign Deutschmark bonds are issued in particular by public corporations and issuers from neighbouring European countries whose bonds are guaranteed by national public institutions, and by supranational issuers (such as the World Bank, the European Investment Bank, etc.). For details on Deutschmark-denominated Eurobonds see the following Euro-Deutschmark section.

Federal government bonds

The Federal government uses a number of instruments to finance its debt (see Chart 4), the most significant being Bunds, which have a maturity at issue of 10-30 years and a volume per issue of up to Dm25 billion. At the end of 1994, the volume of Bunds outstanding amounted to Dm377 billion, corresponding to 51.7% of tradable government paper. Preliminary estimates for 1995 show that these figures increased to roughly Dm430 billion and 55% respectively.

Up until now, Germany has concentrated its secured refinancing in 10-year Bunds and five-year Bobls. In the past, it also issued four-year Bundeskassenobligationen and four-year Bundesschatzanweisungen (Schätze or Treasury notes), but these issues were stopped in 1995. Additionally, there were two 30-year Bunds in 1986 and 1993/94 but these were never issued on a regular basis. A certain part of refinancing also took place via retail paper (including two-year zero-coupon bonds and some long-term paper; these were not traded on exchanges and were not available for foreign investors). Table 1 gives an overview of the capital market financing activities of the federal government from 1990 to 1994 (1995 data not yet available).

Intermediate maturities are covered by Bobls, unlisted Bundesschatzbriefe (federal savings bonds) and – until mid 1995 – Schätze (Treasury notes), which were discontinued in favour of Bobls. In the short-term sector, the Federal government issues unlisted Finanzierungsschätze (Treasury financing paper), U-Schätze (Treasury discount paper) and Schuldscheindarlehen (borrower’s note loans). Federal government paper is issued through a syndicate and/or by auction or sale in the market as a tap issue. The average bid/offer spread in the liquid 10-year sector of the Bund market is usually 6bp.

Futures and options for government bonds

For the hedging and arbitrage of interest rate risks, there is a wide range of futures and options contracts available (principally Liffe’s and DTB’s Bund and Euromark futures and options contracts; for further details see derivatives section). However, the exchanges do not cover the entire maturity spectrum, particularly at the ultra-long end, since the DTB’s 30-year Bund (Buxl future) was discontinued in June 1995.

Bank bonds

Bank bonds can be divided into three main categories:

* Mortgage bonds (Hypotheken-Pfandbriefe);

* municipal bonds (Öffentliche Pfandbriefe) and

* other bank bonds.

Hypotheken-Pfandbriefe are a special instrument created to fund housing loans. They are subject to the Mortgage Bank Act or the Shipbuilding Bank Act. These laws require the bonds to be fully collaterized by first-ranking mortgages. Pfandbriefe are covered by mortgages with an upper lending limit of 60 per cent of the property’s lending value which itself tends to be lower than the property’s market value, thus eliminating the risk of real estate collateral being wiped out by a property crash. Öffentliche Pfandbriefe are issued to fund public sector loans (Schuldscheindarlehen). These act as the collateral.

In 1995, a new liquid segment of the Pfandbrief market emerged: the Jumbo Pfandbrief. May 1995 was the turning point when Frankfurter Hypo launched the first-ever Dm1 billion Jumbo deal with a maturity of four years. Since then more than 60 Jumbos with a nominal value of more than Dm90 billion and maturities ranging from 2.5 to ten years have come onto the market. The term ‘Jumbo’ is used to denote Pfandbrief issues which have a minimum nominal value of Dm1 billion and which their issuers or a consortium quote at a fixed bid/offer spread of 5bp to 10bp, depending on the maturity. This only applies to trading lots of up to Dm25 million. Currently, more than 90% of Jumbos are Öffentliche Pfandbriefe (for details see Pfandbrief section).

The other bank bonds may be divided into issues by special purpose banks (Kreditanstalt für Wiederaufbau, Industriekreditbank, Staatsbank Berlin) and private bank bonds. Special purpose banks issue bearer bonds with a higher credit standing as they are guaranteed by the state. Bearer bonds issued by private banks are secured by the issuing banks’ assets.

Investors: Foreign participation increases …

In the five years since reunification, foreign participants have steadily increased their share of the German bond market. In 1990, foreigners held about 15% of all outstanding Deutschmark bonds from domestic issuers. Since then, they have nearly doubled their market share to about 28% (they have actually increased their holdings of all Deutschmark bonds by 450%). In particular during the bond rally in 1992/1993, they were strong buyers of Deutschmark bonds absorbing the largest share of new government bond issues.

This was at a time when the government had to issue an historically high volume of bonds to finance the restructuring of eastern Germany. This huge amount of new government bond issues would obviously have triggered much higher bond yields in 1992/93 if foreigners had not been prepared to buy all these new issues.

… as domestic market share is down

In contrast, domestic banks have been less active in the German bond market. Their market share has fallen fell from more than 40% in 1990 to less than 37% in 1995, although their absolute holdings of Deutschmark bonds more than doubled due to the increase in issuance. Domestic non-banks (including private investors, funds, insurance companies and corporates) have also seen their market share fall since 1990 to 35.1% in 1995, However, since a low of 32.4% in 1993, their market share may increase and these institutions may regain their former importance. (See Table 2.)

A more detailed analysis of foreign investors in Germany (for all capital market products, i.e. including equities, derivatives and money market instruments) is given in Table 3. It underlines that investors in – or rather via – the UK are the most important international investors in German securities and that this group shows the most volatile behaviour of all foreign investors. Investments from Japan and South-East Asia are also quite volatile. The importance of Luxembourg depends strongly on tax decisions in Germany, while there is quite stable demand from Switzerland and the US.

Foreign interest uneven

However, the importance of the different investors for certain specific sectors of the bond market can only be seen by separately analysing their market share in these specific sectors. This is because of uneven distribution of buying and selling activity between different investor groups and between different market sectors.

Although issuers of bank bonds have had some success in their recent efforts to boost foreign investors’ interest in the German Pfandbrief market, many foreigners still concentrate their investments in government bonds and Eurobonds. Nevertheless, this is changing gradually and the launch of a new segment of the Pfandbrief market, the Jumbo market, has made Pfandbriefe much more attractive to foreigners today.

Table 4 gives an overview of the market share of certain investor groups for the Pfandbrief and public sector bond markets since German unification. Foreigners are now the single most important investor group in public sector bonds (including Bunds, Länderanleihen, Treuhand, Unity, Bahn, Post etc.) with a market share of nearly 40%, this even reaching 44.3% in the bull market of 1993 on the back of the strong appreciation of the Deutschmark and the severe recession in Germany.

In contrast, all domestic non-banks have a relatively low market share, while foreigners held only 15% of all banks bonds in 1994 – though they increased their share in that segment from 3.5% in 1989. Table 4 also shows that domestic funds, insurance companies and private investors are more active in bank bonds than in public bonds. This is partly a result of special legal rules, but is also caused by the yield pick-up that bank bonds offer. The importance of insurance companies in the bank bond market would be even clearer if the table included registered bonds, but data on these bonds is not available. The statistical remainder (the part which can not be attributed to a special investor group) is revealed in the Bundesbank data and is added to the banks in Table 4.

The rising market share of foreigners in recent years can be mainly attributed to the changing behaviour of funds and other institutional investors towards more international diversification. Furthermore, reforms to the German capital markets have modernised them and made them much more accessible to foreign investors.

As a result, the dependency of the German bond market on international developments, in particular those in the US, has increased tremendously in the last couple of years. This is also confirmed by our correlation analysis (see Table 5) which reveals the strong influence of US Treasuries in the 1990s (on Bunds and other bond markets).

Market perspectives

The biggest challenge for the German bond market is without doubt the introduction of Emu from 1999 onwards. Even in an Emu environment, national governments will continue to play an important role as issuers. To enhance the German government’s chances of becoming the Euro benchmark issuer and to strengthen Germany’s ability to compete as a financial centre, further reforms to the German capital markets are needed. They include, inter alia, the rapid conversion of all securities to Euros, the admission of short-term debt paper, the introduction of a primary dealer system and regular issuance of ultra-long bonds. Otherwise, when confronted with a future Eurobond market, German market participants may be at a competitive disadvantage, in particular against France. The German government and the Bundesbank are aware of this situation and have already indicated that short-term debt paper (two-year Treasury notes and six-month Bu-Bills), along with coupon-stripped bonds will be issued during the second half of 1996.

The Bundesbank also urges Germany to re-establish 30-year Bunds issuance on a more regular basis. As far as the new Bu-Bills are concerned, it seems that Germany will be able to issue six-month paper via regular auctions starting in the third quarter of 1996 at the earliest. From a current perspective the third quarter looks rather ambitious, however.

These auctions may take place quarterly or every six months. To gain the Bundesbank’s approval, the volume of the new issues will be limited to a fixed number (the exact number still has to be decided on, but a volume of Dm50 billion seems to be the maximum). A rough indication for a possible limit can be taken from the so-called Bulis. This special short-term paper was issued via the Bundesbank in 1993 and 1994 and reached a maximum volume of Dm25 billion in 1993. There are plans to begin with two quarterly auctions of Dm10 billion each. Thereafter an issuance of Dm20 billion every six months is envisaged. Note, however, that these plans are not officially confirmed yet – neither by the finance ministry nor by the Bundesbank.


Chart 1: Size of the international bond market






Table 1: Gross borrowing of Federal Government

Table 2: Deutschmark bonds outstanding from domestic issuers (Dm bn)

Table 3: Foreign buying of Dm bonds, equities, money market products and derivatives (Dm bn)

Table 4: Investor structure of Deutschmark public and bank bonds 1989-1994

Table 5: Yield correlation with US Treasuries*