It used to be hard to find anyone in the financial markets prepared to criticize the Pfandbrief. Analysts would continually extol the virtues of the second-largest bond market in Europe for its generous yield pick-up on German government bonds, for having the backing of practically risk-free loans to the German Länder (states) or to a pool of high-quality mortgages, and for not having suffered a default this century.
The only shortcomings mentioned were its lack of liquidity and transparency. That meant it was characterized as something peculiar to the German domestic debt market. Deemed unsuitable for export, on average only 10% of the paper was sold to investors outside Germany.
The development of the jumbo Pfandbrief in 1995 was an attempt to change that. Any Pfandbrief issue of Dm1 billion ($649 million) or more offering a fixed rate of interest and with at least three market-makers in the dealer group was henceforth to be classified as a jumbo. The consequent increase in liquidity and transparency was expected to persuade international investors that they had been missing out on an excellent opportunity. At least that was the plan.
The jumbo Pfandbrief has certainly been extremely successful. In 16 months outstandings have already surpassed Dm100 billion and are expected to top Dm120 billion by the end of the year. And virtually all issues remain liquid and are being actively traded in the secondary market: “Our first jumbo still gets a six-pfennig spread quoted on it today, 18 months after it was issued. Compare that with the Eurobond market, where liquidity all but dries up after a year or so,” says Friedrich Munsberg, head of treasury at Frankfurter Hypo, Deutsche Bank’s mortgage subsidiary.
Yet international investors remain unconvinced. According to a Frankfurt-based banker it is rare for more than 15% to 20% of jumbo paper to be placed abroad, little more than was achieved with the traditional, illiquid Pfandbrief. And even these figures are controversial. A banker at a key Pfandbrief-issuing house claims that as much as half of all supposedly internationally placed paper is going to subsidiaries of German companies, an opinion several of the larger German institutions share. “A lot of this so-called foreign paper is just going to certain addresses in Luxembourg and Switzerland,” says a German banker. “It would be more accurate to describe such placement as domestic.”
Other market participants mention fears that much of the internationally placed jumbo paper is bought by investors playing the spreads, and flows back to Germany almost immediately. “How can you possibly claim success in attracting foreign investors when 50% to 60% of paper is sold back to German investors within days of launch?” asks a London-based analyst. In Germany, though, there is less concern. Says Gina Leu, head of global fixed income and derivative institutional sales at DG Bank: “For some it’s simply part of their investment strategy to buy to sell, regardless of the product. And it still achieves our aim of making the Pfandbrief known to international investors.”
Impatient borrowers
One of the fundamental reasons that so little paper is placed abroad is the lack of information available to investors. International investors want more than a show of liquidity and a triumvirate of market-makers, and it is here that the Germans have in the main failed to make much progress.Often little distinction is made between a DM50 million private placement and a public jumbo issue of DM1 billion. Manfred Ludwig, director of debt markets at Merrill Lynch Capital Markets in Frankfurt, sums up the problem: “The borrowers are very clever and clued up about market trends, but they rarely get investors involved before they issue. They’ll monitor the situation and when they see a good opportunity some of them just ring up and say ‘We want to do a Dm1 billion jumbo now.’ They expect it to go on the screen immediately and be sold within a couple of hours.”
This might work well for German investors, who know the product inside-out, but it is a sure way of excluding the foreign investors that the jumbo was designed to attract. Liquidity is all very well, but most international investors are also looking for discussions on price discovery, and the market-makers, German and foreign alike, would prefer to have time to build a book.
A second anomaly that deters foreign investors is the way jumbo prices are quoted. Being credit businesses, the mortgage banks that issue Pfandbriefe generally talk in Libor terms, which gives little or no information to those investing in the fixed-rate jumbo. “This does create problems when trying to attract international investors,” says Herman Collmann, vice-president of domestic trading at Düsseldorf-based Trinkaus & Burkhardt. “The Libor spread is of great importance to the Pfandbrief market, but international investors only ever look at Bund spreads.”
Alternatively, jumbo prices are quoted as a spread based on the traditional illiquid Pfandbrief. Again, for the vast majority of foreign investors this is meaningless: they have never been involved in the traditional market so such a pricing system cannot serve as suitable terms of reference.
This problem should be solved, in part at least, as more issuers obtain credit ratings from the main international rating agencies, Standard and Poor’s and Moody’s. This, though, is likely to be a slow process because many issuers still don’t see the need for ratings, believing that the history of the product should speak for itself. The Association of German Mortgage Banks is at pains to point out that ratings were not necessary before the Pfandbrief went international. But for many international investors a rating is the only effective method of assessing domestic, non-government debt. And with the impending introduction of European Monetary Union (Emu), spreads between products in the participating countries will be all-important, and ratings the main way of setting them.
However, the present situation entirely suits the needs of some Pfandbrief issuers, allowing them to make quick money while at the same time abrogating responsibility for handling the paper after it is issued: “Some of the smaller banks take advantage of the uniformity of the product to play the yield curve, especially at the short end,” says a banker at a top German institution. “They can lock in 20 basis points profit while shifting all responsibility for trading the paper to the market-makers. It’s a free lunch for them at both ends.”
Ready for monetary union
The largest issuers of jumbos on the other hand are developing a more strategic approach. Bayerische Vereinsbank, for example, was one of the first to take a leap into true Euromarket-style marketing. Rüdiger Jungkunz, head of mortgage bond trading, explains the bank’s thinking: “Our plan is to prepare as best we can for Emu. The most effective way to do this is to strengthen our main market, namely the Pfandbrief market. We’ll be faced with Europe-wide competition, so it’s imperative that we achieve success with international sales and placement.”
Bayerische Vereinsbank this year embarked on a three-stage issue plan to increase the proportion of its paper placed abroad from 10% to 70% and to promote itself as the leader in developing the jumbo Pfandbrief. The first jumbo, in January 1996, was for Dm1.5 billion, and the second and third which followed in May and September were both for Dm1 billion. All were set up and marketed in Euro-style language, with a fixed reoffer price and prices quoted at a spread over Bunds. A wide range of foreign houses were included in the dealer group: Goldman Sachs, UBS, Merrill Lynch and, in the third issue, French bank Caisse des Dépôts et Consignations. Although the first issue was seen by many as too domestically oriented, it still achieved 25% foreign placement. The second issue went 40% abroad, and with the third Vereinsbank achieved its aim of increasing it to 70%. The next stage will be to go for a global issue with the intention of issuing two or three globals each year.
Vereinsbank was also prepared to pay its way into the market. “We issued at a more favourable rate than our competitors to get name recognition,” says Karl-Heinz Priester, the bank’s head of fixed-income. “And we’ve seen that investors are happy with our paper and that spreads are tightening in the secondary market.” In addition, it paid a fee of 25 basis points to its syndicate groups for the three issues, thus far the only jumbo issuer to do so.
Vereinsbank’s approach has been welcomed by other market participants. Merrill Lynch’s Ludwig holds up their jumbos as the most successful, with the tightest spreads to Bunds and the widest international placement. And Standard and Poor’s has just assigned a triple A rating to Vereinsbank’s four jumbos, which seems to confirm Priester’s belief that its jumbos could become the benchmark.
The Deutsche Pfandbrief- und Hypothekenbank (DePfa Bank) and Rheinische Hypothekenbank (Rheinhyp, a subsidiary of Commerzbank), are the other two institutions that have done the most to promote the Pfandbrief jumbo abroad. Unlike Vereinsbank, they have yet to pay fees to their dealer group, and have both issued global jumbos already or at least Euro-style paper with a 144a exemption in the US. Of the two, analysts think that DePfa has had more success in placing its paper abroad, although there were doubts about its claim that 30% of its first global, in February last year, went to US investors.
It is in the secondary market where the difference in approach shows up most between these two and Vereinsbank. Although the spreads on the latter’s Euro-style jumbos have tightened to the narrowest to Bunds, the global issues are trading at dearer prices than many of the jumbos, possibly a sign that international investors weren’t quite ready for them.
But the feeling is that all three issuers have taken the first necessary steps in internationalizing the Pfandbrief. “The first issues of this type do cost money, but it does bring name recognition,” says Munsberg at Frankfurter Hypo.
The biggest test for the jumbo will come when it has to deal with a bear market. The main concern among some dealers is that the market-making process designed specifically for the jumbo Pfandbrief might not stand up to the pressure of higher interest rates.
Under the rules laid down for market-makers in the jumbo Pfandbrief, the dealers are contractually obliged to make a market for the paper. Bidoffer spreads are exactly regulated, being between 5bp and 10bp depending on the time to maturity of the paper.
The advantage of this system is that it guarantees a secondary market that is far more liquid than the Eurobond market. The imposition of liquidity was an effective way of getting the jumbo Pfandbrief market started, but is now seen as a potential hindrance to further development.
“We don’t need such official sponsoring any more,” says Mathias Preller, head of fixed income at BZW in Frankfurt. “The market is mature enough and of good enough quality for it to stand on its own two feet. And it’s costing some market-makers dear to have to quote bid and offer at fixed prices. How many millions are the German banks willing to spend to keep this going?”
Rumours abound that some market-makers are losing money already. Leu at DG Bank explains: “I’m sure some have made a loss because of the price-sponsoring guarantee. But it’s not easy making money from this business in any case.” Leu believes price sponsoring will be phased out over time. Deborah Kasner Goedeking, head of syndicate at Trinkaus & Burkhardt, is not so sure: “The commitment to the market-making process was undertaken so publicly that none of the banks will simply back out. And certainly none of the main German banks.”
If dealers are already losing money, their position in a bear market could become precarious. As interest rates rise investors may dump their jumbos on the market-makers, who will then be stuck with them. “If that were to happen, liquidity would simply dry up. The only trading would be between the market-makers,” says a banker at a foreign house in Frankfurt.
A boost to liquidity?
An effective counterbalance to this would be a workable repo market for jumbo Pfandbriefe. “The jumbo market might be liquid and visible, but market-makers often have to quote offer prices on paper they don’t possess,” says Ludwig at Merrill Lynch Capital Markets. “Without a repo market that situation is simply untenable.”
This poses no particular problem for the large German banks because they hold a large quantity of various issues in their own portfolios. But they too are pushing for a repo market. Frankfurter Hypo’s Munsberg says: “The development of a functioning repo market is one of the most important next steps since only this will produce genuine market liquidity. It will also allow for proper, effective refinancing of jumbo Pfandbrief positions.”
But there had always been two stumbling blocks. Collmann at Trinkaus & Burkhardt explains the first: “We tried very early on to create a repo market for jumbo Pfandbriefe, but found that there was very little interest on the part of investors. That said, repo deals are easier than they were a year ago.”
The second stumbling block concerned the Bundesbank’s minimum reserve requirements. On each repo deal 2% had to be set aside in a non-interest-bearing account with the Bundesbank, effectively wiping out any profit and so making the transaction pointless. This should no longer be a problem, though. The Bundesbank announced at the beginning of last December that it was abolishing these rules from January 1997.
A functioning repo market is universally regarded as more important for the success of the jumbo Pfandbrief than a futures market. The general feeling is that underlying liquidity is not yet sufficient to merit its introduction: “For the futures market to work it would need underlying liquidity of Dm60 billion as a bare minimum, possibly Dm80 billion,” says Karl-Heinz Kröll, senior vice-president, domestic fixed-income sales, at Bayerische Landesbank. “As a rough guess I’d say we’ve probably only got Dm30 billion at present. And most of that is at the five-year maturity. But we need the futures to be based on 10-year maturity because that is regarded as the benchmark.” Such caution is understandable: in June 1995 the Buxl future (for 30-year bonds) had to be withdrawn because of a lack of liquidity it too stood at Dm30 billion.
Some are not convinced that a futures product would be workable even if the underlying liquidity were present. “Investors like to know whose paper they hold,” says Helmut Brocks, director of international sales at WestLB. “But in a jumbo Pfandbrief future they just wouldn’t be able to tell. And as ratings become more prevalent and spreads diversify it will be of even more importance for them to know which paper they’ve got.”
Many also suggest that a jumbo future would be superfluous once there was enough underlying liquidity. By that time jumbo spreads should be as tight as 4bp to 10bp over Bunds, more than adequate for the Bund future to be used as an effective hedging instrument.
But the emergence of a repo market and some form of hedging will signal that the jumbo has reached maturity. BZW’s Preller sums up the development so far: “It’s not a baby any more, but neither is it a fully grown adult. It needs to move away from price sponsoring and embrace the globals the jumbo is just a stepping stone. But it’s getting there.” It’s a feeling shared by most observers, and it looks as if the Germans are developing the market at exactly the right time and adopting a pragmatic approach to regulatory changes. If the jumbo market continues to expand as fast as it has up to now, it stands every chance of becoming the benchmark for non-government euro-currency bonds after the introduction of EMU in 1999.
