IntroductionThe German bond market has undergone dramatic changes over the last few years. Not only has liquidity increased sharply owing to higher borrowing in the wake of German reunification, but at the same time important new instruments have been established across the government yield curve ahead of Emu and in the context of the competition for becoming the European benchmark issuer. Moreover, the Pfandbrief segment experienced significant reforms in the last two years in the light of global competition in international capital markets. Since 1980 the volume of outstanding domestic Dm issues has risen by an average 12% per year. Thus, the total volume of Dm bonds outstanding has roughly doubled compared with 1990. The market for Deutschmark–denominated Eurobonds has experienced similarly rapid growth, volume having been persistently boosted as issuers and investors were drawn to an until recently appreciating currency. 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. 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 an outstanding volume of Dm3,667 billion (at the end of February 1997) occupies the leading position. Types of bondsGovernment The most important German long-term government bonds are Federal bonds (Bundesanleihen, commonly known as Bunds). Bunds traditionally have been the main long-term borrowing vehicle of the Federal government since they were first issued in 1952. They play a key role in the German capital market and in financial transactions with non-residents, and are important benchmarks for the Dm debt securities market as a whole. Bunds are issued as bullets and with three exceptions have a maturity of 10 years. With the announcement by the Bundesbank that it is to issue 30-year bonds on a regular basis once a year from July 1997 onwards (“if market conditions are appropriate”) there is renewed hope that an ultra-long end segment will be established. Similar to Bunds with respect to terms and conditions are Treuhand bonds, German Unity fund bonds and ERP bonds. The respective medium-term instrument are Bobls: they are issues of the Federal government with a maturity of five years. They are of key importance in the medium-term market segment. They are serial (tap) issues launched with a fixed coupon and variable issue prices. However, only the latest series is sold via tap. Once a new series is launched the remaining volume of its predecessor is sold via tender. The Treuhandanstalt issued Treuhandobligationen (Tobls) which offer characteristics similar to Bobls between March 1993 and the end of 1994. Federal savings bonds (Bundesschatzbriefe) are medium-term tap issues of the Federal government that are offered to retail clients. However, they cannot be bought by foreign investors. The most important instruments at the short end of the curve are six-month Bu-bills (in denominations of Dm1 million) with an issuance volume of around Dm10 billion each quarter and two-year Schätze (in denominations of Dm 1,000, issuance volume of around Dm10 billion each quarter). Bank In the past, the banking sector was the most important debtor, due to its dominance in new issuance. However, it has now been replaced by the public sector as the most important issuer. Bank bonds can be divided into three main categories: Mortgage bonds (Hypotheken-Pfandbriefe), municipal bonds (Kommunalobligationen or Öffentliche Pfandbriefe) and other bank bonds. The other bank bonds are either issues by special purpose banks (Kreditanstalt für Wiederaufbau, Industriekreditbank, L-Bank) or issues by private banks. Special purpose banks issue bearer bonds with a higher credit standing because of their public backing. Bearer bonds issued by private banks are secured by the issuing bank’s assets. Corporate Although liberalisation has taken place over the past few years, the domestic corporate bond market is still inhibited by a number of factors, mainly induced by the corporate culture in Germany and domestic tax laws. Most of the problems have also led to an equity market that is internationally underdeveloped and the lack of a notable venture capital market. In 1996, only three bonds (issued by VIAG AG, Autobahn Tank & Rast AG and Harpener AG) with a total volume of around Dm2.7 billion were in the market: the share of corporate bonds in the domestic bond market has always been negligible. Euromarket The Dm bond market is the most varied sector in the Dm bond market and has gained increasing importance as an attractive investment alternative to the US bond market for many international investors. The Dm Eurobond market has steadily increased its market share over the years as the Bundesbank has abolished many obstacles which had once reduced the attractiveness of the Dm Eurobond markets for foreign issuers and investors. In 1985, the Bundesbank allowed German-based subsidiaries of foreign banks to lead manage Dm Eurobond issues and opened the market to more innovative debt instruments such as FRNs, zeros and dual currency bonds. Since 1989, the Bundesbank no longer requires lead managers to inform it ahead of a planned issue, paving the way for issues on a standby basis such as medium term notes (MTNs) and commercial paper (CP) programmes. In 1992, the Bundesbank said it no longer required Dm bond issues to be governed by German law or to be listed on a German stock exchange. Since then bonds can also be listed at non-domestic bourses, mostly Luxembourg and London. However, the lead manager of a Dm issue must still be a bank domiciled in Germany. Apart from asset-backed securities (the first ABS issues were launched in 1996), Dm Eurobonds are usually not collateralized and are issued as unsecured and subordinated debt. Denominations are usually Dm1,000 or Dm10,000. Bonds are usually redeemed as a bullet at par, but other payment forms are also regularly used. The yield is calculated on a 30/360 basis. For fixed coupon bonds, coupon payments are almost exclusively on a yearly basis. CP/MTNs Apart from the usual syndicated bond offerings, MTN or CP programmes provide the issuer with more flexibility. Under an existing credit line, the issuer has the flexibility to draw new lines under an existing programme as and when necessary. CP is money market paper in the form of discounted debt securities with maturities between 7 days and less than 2 years which are used to raise short-term funds. CP programmes are designed in such a way that issuers float such paper depending on borrowing requirements and market conditions; the agreed (individual) volume of the programme must not, however, be exceeded. Incidentally, the maturity of the programme as a whole is not limited to the maximum maturity of 2 years applying to the individual CP so that such programmes allow short-term financing on a revolving basis. Some companies have also started programmes for MTNs, even multi-currency amounts, since these instruments became possible in 1989. These instruments are gaining in popularity. FRNs have also been used as well as more structured debt instruments. Asset- Backed Securities 1996 saw the first asset-backed securities (ABS) issued both as fixed and variable rate bonds in the Dm Eurobond market, all rated triple-A and backed by credit card receivables and auto leases. As credit cards become more popular domestically and automobile firms securitize their loans or leasing operations, this market has the potential to grow, especially as there is investor demand for top-rated paper which gives a good pick-up over comparable securities. Variable rate ABS are well bid due to the dearth of quality FRNs and CPs in Dm.
Main borrowersIn terms of volume outstanding, bank bonds play a predominant role in the German bond market (a 50% share in 1996), ranking above public sector issues (36%). The share of Dm Eurobonds stands at 13% while corporate bonds play only a minor role in the German bond market (below 1% in 1996). The composition of issuers in the Euromarket is very heterogeneous. Private and public banks have been the most active issuers at the Dm Eurobond market in the last 15 months but sovereigns, supranational issuers, several European governments and other authorities are also important players in the market (see Table 1). In comparison to those groups, international and private corporates play only a minor role in the Dm Eurobond market. Non-German corporates tap the market when swap rates are attractive, but are reluctant to carry unhedged Dm debt on their balance sheet due to the secular appreciation of the Dm. In the early months of 1996, the market has seen the first long-term issues by low rated central government issuers, namely 15-year Eurobonds for the Republic of Argentina and 30-year Eurobonds for Brazil. The public sector, as a group of issuers, comprises the following agencies:
* The Federal government and its special funds Issuance proceduresThere are a variety of methods for selling the individual public securities, depending on the type of securities or purpose of the placing: * Since August 1990, the majority of Federal bonds has been issued by a combined method, ie one part is issued under a syndicate procedure and the other by tender. * Treasury discount paper, Bu-Bills, two-year Schätze and parts of Bobl issue amounts are sold by tender. * Tap issues of the Federal government (part of Bobls, Federal savings bonds, Treasury financing paper) are sold in the open market, ie with no fixed issue period and no issue volume set in advance. * In the case of Bunds, two-year Schätze and Bobls, a portion of the issue amount is set aside for market management operations before listing and being sold in stages in the open market by the Bundesbank through the stock exchanges. Generally Länder bonds have been issued via syndicates with the state central bank acting as the lead manager. The state central bank generally retained a percentage of the issue for the purpose of market regulation on the stock exchanges. Recently the issuance procedure of Länder bonds has been modernized to meet the requirements of the international investor. Länder jumbos, being joint issues of several Länder to enhance liquidity via a larger volume, are becoming more and more popular. Bank bonds are usually issued on a permanent basis (tap issuance), but also increasingly via syndicate (jumbo Pfandbriefe). Deutschmark Eurobonds are issued via syndicate. Regulations, syndicationBunds are issued by the Federal Bond Consortium under the lead management of the Bundesbank. The members of the Federal Bond Consortium are credit institutions located in Germany which engage in securities business and have a significant power to place Federal securities. Until July 1986 the range of syndicate banks was limited to German institutions, thereafter foreign-owned, legally independent credit institutions located in Germany were also admitted as members. Since 1992, membership of the Federal Bond Consortium is, in principle, also open to foreign bank’s legally dependent branches located in Germany. The admission of foreign institutions took account of, among other things, the increased importance of foreigners in the placing of Federal securities. At the end of October 1996, the Federal Bond Consortium consisted of 89 institutions, including 37 foreign-owned banks. If a bond is to be issued, its terms (volume, maturity, coupon, issue price) are set in the Inner Committee of the Federal Bond Consortium. This committee comprises the Bundesbank as the syndicate leader, the issuer, the Federal Debt Administration and the syndicate banks. The latter are represented by 19 institutions which together account for more than 90% of the underwriting shares. After the terms have been set, a quota offer is submitted to all syndicate banks; acceptance of the offer implies the formation of the underwriting contract with the individual syndicate members. The syndicate members undertake to take up the amount underwritten and to hold the bonds available for sale during the normally three-day selling period on the terms agreed. Pfandbriefe are issued pursuant to two distinct laws: the Mortgage Bank Act (Hypothekenbankgesetz – HBG) enacted in 1900 and the Public Sector Pfandbrief Act (Öffentliches Pfandbriefgesetz – ÖPG) enacted in 1927. The HBG is the special law governing private mortgage banks. All banks subjecting themselves to the provisions of this law, thus acquiring the status of a mortgage bank, are automatically licensed to issue Pfandbriefe. In return, the HBG sets out comprehensive rules regulating the way the mortgage banks conduct their business and, in particular, restricts their business to (essentially) two areas of business: mortgage loans and lending to the public sector. Mortgage banks are therefore specialised banks. Some official statements of the Bundesbank are the basis for the issuance of Eurobonds in Dm. Deutschmark securities should only be issued under the lead management of domestic banks, including German branches of foreign credit institutes. These bonds should not have a maturity of less than two years if they are issued as bearer securities and not less than four years if they are registered securities. Additionally, the Bundesbank wishes to be notified about any new issues or new financial products. There are no other explicit regulations for the Dm Eurobond market. Dealing primary and secondary marketsPrimary markets In mid-1990, the combined syndicate and tender procedure was introduced for Federal bonds whereby the traditional syndicate procedure is immediately followed by a public invitation to tender. This procedure takes into account the individual credit institutions’ varying placing power over time and allows room for competition. The terms of the invitation to tender are transmitted to the syndicate members along with the quota offer. Whereas under the tender procedure for Bunds only the syndicate members are entitled to bid direct, all resident credit institutions holding an account with the main office or branch office of the Bundesbank may submit bids when two-year Schätze, Bu-Bills, and Bobls are being issued. Bids may be delivered to the appropriate central bank office until expiry of the set bidding deadline. Bids must be for * full Dm100,000 in the case of Bunds and Bobls, * full Dm5,000 in the case of 2yr Schätze, * full Dm1,000,000 in the case of 6mth Bu-Bills. In addition to competitive bids, non-competitive bids may also be submitted. After expiry of the bidding period, the bids recorded on a decentralised basis are compiled at the Bundesbank in Frankfurt. Based on the result of the bidding ascertained in this way, the respective issuer decides on allocation. All competitive bids above the accepted minimum price are allotted at the actual price bid (US-style auction). Non-competitive bids are filled at the weighted average price of the competitive bids accepted. If a large amount of bids has been received, the issuer may, in accordance with the terms of the invitation to tender, allot only a percentage share of non-competitive bids and/or competitive bids quoting the accepted minimum price. If the total amount of bids received is too low, or if they consider the prices bid to be uncompetitive, they may prefer to make no allotment. Bidders will be informed of the allotment immediately. They have to make the equivalents available in their local central bank accounts by 11:30am Frankfurt time on the respective value date (as a rule two business days after the bidding deadline). The issuer does not pay any commission to the bidders for the amounts allotted. In the Dm Eurobond market, increasing market volatility and intensive competition have lead the issuing banks and issuers to abandon traditional syndication methods in favour of the fixed price re-offer system. It was designed to return profitability and syndicate discipline to the market, where cut-throat competition had become the norm. Under this system the lead manager would normally indicate the price as a spread relative to a certain benchmark. For a few hours, the issuing banks would then offer their clients the issue at the fixed price. Once a sufficient amount of the issue has been placed the lead manager announces the final terms of the issue and declares the issue to be ‘free to trade’. Only then should normal primary market trading start. This procedure should theoretically prevent the issuing banks from underbidding each other by offering early discounts from the offer price, driving the price down and eroding management fees. Secondary markets Trading of bonds is either on the exchange or over the counter (OTC). The bulk of daily turnover is in the OTC market of which 30 to 40% is executed in London, mainly due to the insufficient repo market in Germany. This situation has changed during 1996 as the reform of the German repo market got underway and repos are now free of minimum reserves. Against this background leading German banks first of all Deutsche Bank have already brought back their whole Dm repo business to Frankfurt. Over the past few years, almost all trading in bonds on the exchange in Frankfurt was in public bonds and only around 2% in Pfandbriefe or other bank bonds. However, the share of Pfandbriefe and other bank bonds in relative trading volume is rising, although absolute volumes remain tiny. Within the segment for public bonds those issued by the Federal government and its special funds have the highest turnover. Trading volume in bonds issued by the Länder or municipals only reached a share of around 3% in 1993 before declining to under 1% one year later and increasing slightly again in 1995. Apart from that the second largest trading segment at the exchange in Frankfurt is the Dm Eurobond market covering around 4.5% of the entire trading volume in fixed-income securities in 1995 and 4.3% the year before. During official exchange trading, a fixing price (Kassakurs) for all bonds is settled, via open outcry, at which the highest turnover can be made for the given orders at that specific moment. The fixing on all eight exchanges is managed by official brokers who are supervised by the local finance ministry; the fixing prices can differ. The Bundesbank takes part as a quasi-market maker in the fixing process of the paper (launched by the Bundesbank) in order to smooth the market via selling or buying. The fixing process provides a free option for liquidity as the Bundesbank always gives a bid price and odd lots can be traded. Investment funds have to use fixing prices when marking their portfolios to market. Traders often use fixing prices as a benchmark for their pricing. After the fixing, which starts at 11:00am through to around 1:00pm, further trades on the exchange at non-fixing levels are possible, but rare. If there is no turnover in a specific bond the fixing price is settled by the exchange according to the market situation. Dm Eurobonds are traded mainly in the OTC market. We estimate that only around 10% to 20% of total volume is traded on an exchange. Depending on the intention of the issuer and the lead managers, new Eurobonds are listed between three weeks and several months after being launched. However, some of the bonds remain unlisted. In the OTC market much of the volume is traded through non-official brokers. Bonds are usually traded and hedged off the five and 10-year futures contracts as well as off their underlying benchmarks. The liquidity of the market and the single bonds is driven by various factors. In contrast to the jumbo Pfandbrief market there is no general agreement between the lead manager(s) of a bond concerning the bid-offer spreads. Furthermore, there is no regulation by ISMA concerning the pricing, the liquidity or trading in general. The lead managers have no obligations to make a market, but they usually provide the highest liquidity in the bonds they managed at issuance. Each lead manager can price the bond individually and give bid and offer spreads on the basis of its own goodwill and position. Overall, the liquidity of each bond is mainly influenced by the volume, the intention of the lead manager(s) and the issuers, and the structure of demand. The higher the volume and the more each trading account is willing to provide customers and the market in general with market making, the higher the liquidity is for the bond. Settlement and clearing proceduresThe settlement of officially traded transactions normally requires that the payment and delivery of securities is made on the second business day following the trading day. Domestic settlement and clearing is usually completed via the Deutsche Kassenverein (DKV), a German securities clearing and deposit bank which can be used only by banks. The Deutsche Kassenverein belongs to the Deutsche Börse AG and is responsible for the settlement of trades, whereby it cannot be held liable for counterparty default. In the OTC market, international settlement is possible and is usually three business days after the trade. International transactions are usually settled and cleared using Euroclear and Cedel, two European securities clearing and deposit banks, which also cannot be held liable for counterparty default. Schuldscheine and registered bonds cannot be held with Euroclear or Cedel. Dm Eurobonds are usually settled after three business days on the OTC market and after two business days for transactions on the official bourse in Germany. This settlement procedure on the OTC market was also implemented in June 1995. Settlement and clearing procedures are equivalent to Dm bonds. For Schuldscheine, the settlement period is subject to negotiation. Trades in the Pfandbriefe market are usually made free of payment and settled after two business days, although a settlement period of three days, in line with general practice, is being discussed. YieldsBonds usually pay annual coupons in arrears, with the exception of floaters and zero coupon bonds. In the German bond market two different yield calculation methods prevail: Moosmüller and ISMA (International Securities Market Association). The Moosmüller method is a German calculation model which differs slightly from the ISMA model generally applied in the Euromarkets. As fractional accrued interest is extrapolated on a linear basis (excluding compound interest) to obtain an annualised yield, the yield calculated through the Moosmüller method will tend to be marginally lower than that obtained by using the ISMA formula. Generally speaking ISMA is applied in markets where participation of foreign investors is strong, such as the market for Bunds. The Pfandbrief market, on the other hand, predominantly employs the Moosmüller formula. Accrued interest, which is not included in the price of a bond, is calculated on the basis of one month equalling 30 days and one year equalling 360 days for bonds. (In the money markets yields are calculated on a actual daycount/360 basis.) Regulation and fiscal policyUnder Article 115 of the German constitution (Grundgesetz – GG, see below), raising loans to finance the Federal budget requires authorisation for a specific amount under Federal legislation. Such authorisation is provided for in the Budget Act to be passed each year by parliament. Additional authorisations under a Supplementary Budget Act are required if further borrowing should prove to be necessary during a fiscal year. The Federal finance ministry is, in principle, free to choose the financial instruments and maturities of borrowing. Constitution Article 115 (1) The taking up of loans and the granting of securities which may lead to expenditure in future fiscal years require authorisation by Federal legislation at a definite or definable level. The proceeds of loans must not exceed the sum total of capital expenditure provided for in the budget; exceptions are permissible only to avert a disruption of domestic economic equilibrium. The details shall be regulated by Federal legislation. The respective authorisations in the relevant laws and economic plans apply to borrowing by the Federal special funds. Similar provisions also applied to the former Treuhand Agency and the former Federal special funds, the former German Federal Railways and the former German Federal Post Office. Investors: residents and non-residentsSince reunification, foreign participants have steadily increased their share of the German bond market. In 1990, foreigners held about 15% of all outstanding Dm bonds from domestic issuers (see Table 2). Since then they have nearly doubled their market share to nearly 29% (they have actually increased their holdings of Dm bonds by 450%). In particular during the bond rally of 1992/1993, they were strong buyers of Dm bonds, absorbing the largest share of new government bonds issued. This was at a time when the government had to issue a 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. In contrast, domestic banks have lost market share in the German bond market. Their share fell from more than 40% in 1990 to around 35% in 1995, although their absolute holding of Dm bonds more than doubled due to the increase in issuance. Domestic non-banks (including private investors, funds, insurance companies and corporates) have also lost market share since 1990 from 38% to 33.3% in 1995.
Future prospectsThe most important issue pertaining the future prospects of the German bond market is of course the possible abolishment of the Deutschmark in 1999 if European monetary union enters into its final stage. This means that the German market’s unique selling point the Deutschmark will disappear, which used to be the world’s second reserve currency and a safe haven for domestic and international investors. It is not yet clear, whether the future bond market denominated in Euros will be anchored in Germany, as with the currency edge gone, the technical, procedural and regulatory environment will determine who will become the European benchmark issuer. The most efficient market will attract the lion’s share of the business. The focus in Germany will be probably more and more on the other market segments besides Bunds, eg the swap and Pfandbrief market. While the internationalization of the Pfandbrief market may have monopolised many of the headlines in the capital market press in 1995 and 1996, it is important not to lose sight of a more general trend of German bond issuers accessing international investor bases for the first time. This has been especially apparent in the banking sector. While heavyweight German banking institutions such as Kreditanstalt für Wiederaufbau (KfW) and L-Bank have long been popular fixed-income borrowers in the international market, these were joined in the first half of the 1990s by an ever expanding list of bank borrowers, such as Deutsche Ausgleichsbank and Landesbank Rheinland-Pfalz, the first of the German Landesbanks to have issued a Samurai bond aimed at Japanese investors. Another new category of international borrowers emerging from Germany are the Sparkassen or savings banks which have also started to secure investment grade ratings and to access international markets for the first time. Although there are around 600 Sparkassen in Germany, expectations are that only 10 or 15 or these are sufficiently large to tap the overseas market. Away from the banking sector, other newcomers have been successfully tapping international markets, such as the German railway company, Deutsche Bahn, which made its international debut in 1995 with a Dm1 billion seven-year bond co-led by Deutsche and Dresdner Bank. Another refreshing development in Germany’s bond market came in April 1995, with the launch of a rare convertible bond from a corporate issuer a Dm1 billion transaction from the giant insurance company Allianz. In the summer of 1996, the interest shown by German bond issuers in the international market led to the German Länder joining forces to issue a groundbreaking Dm4 billion bond aimed at international investors. The issue, known as Länder Jumbo No 1, brought together the states of Berlin, Hamburg, Hesse, North Rhine-Westfalia, Rhineland-Palatinate, Saxony-Anhalt and Schleswig-Holstein. A second 10-year Länder Jumbo was jointly issued by another group of Länder (Berlin, Brandenburg, Bremen, Hamburg, Hesse, Mecklenburg-Vorpommern, North Rhine-Westfalia, Rhineland-Palatinate, Saarland and Schleswig-Holstein) in January 1997. The rationale behind this structure is that many of these states have funding requirements which are too small to justify individual bonds aimed at the international community which would suffer from illiquidity. As with the landmark developments in other sectors of the German capital market in the equity and Dm Euromarkets, for instance this rapid expansion of international bond issuance from German borrowers can only help to enhance the reputation of German issuers at an international level, bolster liquidity in German securities and hence strengthen the global standing of the German fixed-income market. DMG Fixed Income Research Frankfurt Dr. Helmut Kaiser Werner Krämer Dr. Markus Herrmann |
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