Since March three borrowers have issued Pfandbriefe in currencies other than Deutschmarks and in June another became the first to issue a fully registered global Pfandbrief – the previous four so-called globals had all been issued a rule 144A exemption.
These issues represent the next step in the process of internationalizing a market which until two years ago was almost exclusively domestic. The traditional Pfandbriefe were illiquid instruments, usually between Dm50 million ($27 million) and Dm200 million, and sold as quasi-private placements to buy-and-hold investors. They rarely achieved more than 10% to 15% involvement from foreign investors.
Although Pfandbriefe are the second largest bond market in Europe, there were fears that a purely domestically oriented product would lose out in a single-currency Europe. So in mid-1995 the jumbo sector was introduced, offering large issues of at least Dm1 billion through a syndicate of three official market-makers or more.
The sector has proved popular, with over 100 issues raising Dm182 billion by the beginning of July this year. Foreign interest has increased, not just from German subsidiaries in Luxembourg and Switzerland: last year, when the first Euro-144A-style global jumbo Pfandbriefe were issued, anything up to 70% of paper was said to have been placed abroad.
This year it is non-Deutschmark public Pfandbriefe which have caught the imagination of the market. The first name to jump in was Frankfurter Hypo, which issued a ffr2 billion ($350 million) in March. Two years before, it had issued the first non-Deutschmark Pfandbrief, a ¥6 billion ($52 million) private placement. The French franc issue offered investors a new currency and a new tenor of 12 years – few syndicated Pfandbriefe go beyond 10 years – and it contains redenomination and consolidation clauses allowing it, and other currency issues with the same characteristics, to be converted to the euro after 1999.
Choosing the currency was not difficult, says Friedrich Munsberg, head of treasury at Frankfurter Hypo: “We looked at which Emu countries have the largest investor base after Germany, and they are France and the Netherlands. So it makes sense to target those first.”
Munsberg knows the eyes of all other issuers were on him: “Had anything gone wrong it could well have meant the end of non-Deutschmark issuance before it had even begun. So we treated it very much as a strategic issue and made no attempt to try to achieve as favourable funding as we could have done in Deutschmarks. We wanted to be generous to our investors.” So the deal was launched at 16 basis points over OATs, and has since traded in to 14bp. “We wanted to avoid the situation some German banks found themselves in,” continues Munsberg. “They launched their AAA-rated Euro-franc bonds as tight as they could, and they’ve widened out since, whereas ours has tightened.”
Even a year ago few people thought a foreign currency Pfandbrief was likely, and some considered it impossible without prohibitively complex due diligence. “We were always being told that we would have to issue a standard Eurobond, with a grossing-up clause. We proved them wrong.”
One investment bank which stood out by pushing for a non-Deutschmark Pfandbrief was rewarded with a slot as joint bookrunner on Frankfurter Hypo’s deal, much to the surprise of some in Frankfurt. Deutsche Bank was an obvious choice, since the issuer’s parent is virtually guaranteed the top spot, but Morgan Stanley was a name few expected to see. For a deal targeted mainly at French investors, many reasoned that a French institution would be the second bookrunner, and CDC Marchés was the frontrunner as the most established French institution in the Pfandbrief sector.
Morgan Stanley organized many of the roadshows and one-to-one presentations in France, but its role as a co-lead was sealed long before the idea of a franc issue was mooted. “Morgan Stanley went to Frankfurter Hypo about a year ago with the idea for a foreign currency Pfandbrief,” says a syndicate head in Frankfurt. “Although they decided not to issue in anything other than Deutschmarks at the time, there was a gentlemen’s agreement that Morgan Stanley would be a bookrunner when they did.”
Not that CDC – or other French houses – should be too concerned. Munsberg is certain the bank will issue more in French francs before the advent of the euro kills off the possibility. “We don’t think that the foreign currency Pfandbrief will grow to be anything like as large as the jumbo sector,” he says. “But we plan to keep French investor interest going with another franc deal in the next three to six months and possibly one or two next year.”
The swap market may hold the bank back. All the proceeds of the issue had to be swapped back to Deutschmarks to service the collateral behind the paper – the bank does not have enough franc assets to cover the issue. This is one factor which has hindered the foreign-currency Pfandbrief since the Frankfurter Hypo issue. Although some of the big issuers are willing to pay extra to appeal to a new market, they still have funding targets which the weakened Deutschmark and the swap market rates have made difficult or impossible to achieve. “We’d also like to do a Dutch guilder Pfandbrief,” says Munsberg. “And we probably would have done by now if the swap markets weren’t so prohibitive.”
Not a concern
This was not a concern for Rheinhyp’s $750 million Pfandbrief at the start of June (see box) nor for Bayerische Vereinsbank when it issued the first fully registered global Pfandbrief three weeks later. Compared with the Rheinhyp issue, Bayerische Vereinsbank’s Dm2 billion global in mid-June received much wider coverage. Launched through the bank’s New York office under rule 3(A)2, the Dm2 billion deal was also one of the largest Pfandbrief issues to date.
The aim of the issue was the same as the foreign-currency issues – to market the bank’s name and the Pfandbrief product beyond its traditional audience. In this sense there is little doubt that the global did the job. “An investor in Asia is no more likely to buy a Euro-Asian than a Eurobond, but a global will get him to sit up and take notice,” says Rob Jolliffe executive director, debt capital markets, at Goldman Sachs. “And in that sense Vereinsbank’s global is the Rolls-Royce product.” According to Manfred Ludwig, director of the debt markets division at Merrill Lynch, joint bookrunners with Vereinsbank, the 3(A)2 exemption allowed the issue to reach a broader investor base than the 144A Pfandbriefe had: “The Vereinsbank name combined with the deal being public got the US investors interested, so we got orders which a 144A exemption would have excluded. And we also had a good range of ticket sizes from $2.5 million to $90 million.”
Vereinsbank was willing to pay its way into the market, a strategy which it has openly pursued since the start of the jumbo process. This fact worries some of the more conservative bankers in Frankfurt: “Did the Deutschmark global fulfil Vereinsbank’s funding requirements? I doubt it,” says one banker. “Which is a shame, because it’s a very important strategic issue, and from that point of view was a success. But economically it wasn’t – it was the wrong time to issue in Deutschmarks, but they’d spent four months marketing the deal and couldn’t back out. So they had to add a few basis points to get the issue out. It cost a lot more than domestic issues at the time.”
Ludwig disputes this: “At seven ticks under Libor the deal was in line with other triple-A Eurobond benchmarks. It’s difficult to get better funding with a global than you would at home, but in such a competitive market it’s an efficient way of marketing one’s name.”
Most market participants support Ludwig’s view that the global is another necessary step to full internationalization of the Pfandbrief. “It was a well done deal,” says Thomas Geller, director and head of syndicate at ABN Amro. “In pure Libor terms they might not have got as good a deal as they would have liked, but it was well received, tightened after launch, and sold out quickly.” It was also one of the most successful deals to date for international placement: only one quarter was sold to German investors, with 20% going to other European addresses, 24% to Asia, and 30% to the US.
But not all the big issuers are lining up to issue in foreign currency. Half an hour’s train journey from Frankfurt is the more sedate city of Wiesbaden, state capital of Hesse and home to Deutsche Pfandbrief- und Hypothekenbank (DePfa Bank).
Staff at the former state-owned institution view the recent global and foreign currency Pfandbrief issues as positive developments but, much to the chagrin of some syndicate heads, have no plans to follow suit. “We’ve tried so hard to convince them,” says Yann Gindre, global head of debt capital markets at Commerzbank. “A dollar issue from them, the biggest independent Pfandbrief issuer, would really get the sector going. But they just don’t seem to want to bite.” DePfa is one of the big-five issuers and innovators in the jumbo market – it issued the first 144A paper and a Euro-Asian Pfandbrief last year, and has some of the most liquid issues in the market .
“We’ve been looking at the pros and cons of doing such deals,” says Gabriele Müller, first vice-president and co-head of treasury at DePfa. “On the positive side, foreign-currency Pfandbriefe can access a different investor base to that in Deutschmarks. But there’s no generic buyer of foreign-currency Pfandbriefe as yet, and as our assets are in Marks we would also have to increase the costs of the deal by swapping the proceeds, which would also influence the risk profile of our collateral pool.”
For those issues in currencies due to converge into the euro in 1999 Müller certainly has a point. Frankfurter Hypo is only planning a further four or five franc issues, not enough to establish a yield curve, and the longer that issues in guilder, for example, are delayed, the less interest there might be. This is compounded by investors in France and the Netherlands at present getting a better return if they invest in Deutschmark products.
Unlike Frankfurter Hypo, however, DePfa does not concentrate purely on issuing Pfandbriefe; since spring 1993 the bank has also issued 70 international bonds in a variety of currencies. “We’d rather be seen as a two-product issuer, not exclusively a Pfandbrief issuer,” says Müller. “And for tax reasons some investors prefer Eurobonds. This means that the major European investors already know our name. And this has a knock-on effect on the interest European investors show in our jumbo Pfandbrief – a good proportion of our 12-year Dm1 billion deal in February went to French and Dutch accounts, and as much as 70% went abroad in total.”
Jumbos on a plateau
The jumbo Pfandbrief sector has reached a plateau. The imposed market-making process accepted by all as the best way of nurturing the market hasn’t changed; there is no real support for a dedicated futures market to replace the Bund futures as a hedge, and, says Joliffe: “The average size of a jumbo issue is Dm1.5 billion, and most issues are Dm1 billion. This poses no problem at present, but after Emu issues will need to be much larger if the product is to compete effectively with euro-denominated government bond markets.”
Issuers are trying to vary sizes by reopening deals, usually by Dm500 million at a time; and DePfa Bank has increased one of its deals to Dm5 billion. Even so, most agree the market could only benefit from increasing and varying the size of the initial issues, and from a greater diversity of maturities. “I doubt we’d pitch for another five-year 2002 jumbo,” says Hansjörg Patzschke, director of syndicate at CDC Marchés. “There are simply too many of them out there.”
Some borrowers may not have appreciated that their position as big fish in a small pond will change after Emu in 1999. But many also face a dilemma. “Most of them know they have to look abroad for funding, but might not want to pay for it,” says Manfred Ludwig, director of capital markets at Merrill Lynch. “They’re torn between the marketing benefits which a truly internationally targeted Pfandbrief can bring, and the fact that they can currently get cheaper funding at home.”
For some Pfandbrief issuers, the decision has virtually been decided as Schuldscheine, the public-sector debt paper used as collateral for the vast majority of jumbo Pfandbriefe, have become more expensive this year.
As a consequence the foreign houses acting as market-makers – there are now 10 – are conservative in choosing which issues to pitch for. So whereas Deutsche, Dresdner and Commerzbank each acts as a market-maker on 60 issues or more, the non-German banks rarely have more than 12 each on their books. “We prefer those issuers whose name is known beyond Germany,” says Geller at ABN Amro.
The Dutch bank was a latecomer to the Pfandbrief sector, only getting seriously involved since the start of the year, but as a syndicate member it has been responsible for placing about Dm3 billion in jumbo paper, roughly 10% of the total issued this year. Others such as CDC Marchés, Credit Suisse First Boston and Goldman Sachs have followed a similar route into the market, whereas Morgan Stanley and Merrill Lynch can point to a longer involvement.
Hedging inadequacies
Foreign houses are concerned about the lack of a full repo market and a dedicated futures market for hedging. Without these tools, they argue, it is disastrous for a market-maker to take on too many issues, although it might quote prices on other issues for its customers. “If you deal in an issue and you’re not a market-maker, you know that there are always three or four official market-makers there who you can use as a parachute,” says one syndicate head at a non-German bank.
A repo market would enable the banks to take short positions without fear of having no paper to trade. According to one banker, this might run contrary to German tradition, which he describes as “go long and go home”. But without this facility banks are left with two equally unpalatable choices: go short, and maybe encounter difficulties in trading the bonds, or take long positions and risk being overwhelmed with paper they cannot offload.
The last fear stops foreign firms taking on more bookrunner mandates. “We could easily have taken on twice as many market-making roles,” says Patzschke at CDC. “But that would have meant more resources and balance sheet problems.” The German banks, however, are committed to market-making, not least because their mortgage bank subsidiaries account for a large proportion of jumbos.
But the problem with developing the repo market is volume: “A one-year-old Dm1 billion issue will be at least 80% placed, so there would be little need for a repo market,” says Patzschke. “It can only really exist if the issues themselves increase in size. That said, the demand has picked up over the last year – we probably do anything between five and 10 repo trades each week.”
A recent analysis by Deutsche Bank Research into spreads between Bunds, traditional Pfandbriefe, jumbos and swaps appears to confirm a mature repo market for jumbos is some way off, because buy-and-hold investors still dominate. “The analysis showed that normal factors determining spread movements in bonds could not be applied to the jumbo sector,” says Munsberg at Frankfurter Hypo. “Usually divergent credit ratings and differences in liquidity are the driving forces, but for the jumbo it is the coupon effect.”
This effect states that jumbos with coupons above the market level have higher yield spreads over Bunds, with investors preferring paper with coupons below market levels as this is more beneficial to them for taxation and accounting purposes. So there is less attempt to take advantage of pricing anomalies. “This tells us that a lot of investors are still following a long-term buy-and-hold strategy, while also liking the fact that they have the option to sell their paper,” says Munsberg.
Many of the jumbos issued in the market’s first few months were little more than larger versions of traditional Pfandbriefe: issuers would call potential market-makers and expect to see the paper placed within a few hours to the usual domestic investors, so there would be no need for a roadshow, and there was little expectation that investors might want to trade after the initial placement.
Despite the traditional buy-and-hold culture, several German mutual funds have set up departments to trade price anomalies. “In time, though, the old truth will apply here too,” says Munsberg. “The more players there are in the game, the sooner it will lose its charm.”
