Europe’s largest bond marketOver the last two years one of the most important trends within the German capital market has been the internationalization of the Pfandbrief market. The process has evolved as German issuers have acknowledged that over the longer term they can reduce their overall borrowing costs if they diversify away from their historical reliance on the domestic investor base. At the same time, international investors have increasingly recognised that the Pfandbrief market, which has now become the largest European bond market in terms of total volume outstanding, is simply too large for them to overlook. By the end of 1996, the market was worth a total of Dm1,431 billion. In total, the Pfandbrief sector now accounts for 36% of the entire German fixed income market, compared to 26.5% for federal government bonds, 19.3% for other banks bonds, 11.9% for eurobonds and 6.3% for other public sector bonds. Important market developments in 1996For the German Pfandbrief market, 1996 was a critical year and one which reconfirmed that the instrument had gained popular international acceptance as a liquid alternative to the German government bond market offering the enviable attraction of a healthy yield pick up over Bunds – of between 10 and 30 basis points twinned with proven stability and creditworthiness. Although the Pfandbrief has been a well-established and highly popular fixed income instrument in the domestic market for more than 100 years, the initiative aimed at internationalising the product is a relatively recent phenomenon. Initially, this initiative on the part of individual issuers and the Association of German Mortgage Banks (VdH) focused on impressing on international investors the very clear differences between the German Pfandbrief and mortgage and other asset-backed securities familiar to the investor base in the US. Pfandbriefe/mortgage-backed securitiesThe principal difference between the German Pfandbrief and its first cousin the mortgage-backed bond in the US is in the collateral backing the instrument. In the Pfandbrief market, no bond is ever secured against any individual loan per se. Instead, the collateral backing the Pfandbriefe is a large and separately registered pool of loans. These can either take the form of loans to the public sector, in the case of the public Pfandbrief (Öffentlicher Pfandbrief), or first mortgages on residential or commercial properties, in the case of the mortgage Pfandbrief (Hypothekenpfandbrief). A further in-built security mechanism which distinguishes Pfandbriefe from mortgage-backed bonds in other markets is that no mortgage eligible as collateral is allowed to exceed 60% of its prudently assessed lending value. Another critical point for investors to be aware of in their evaluation of the security behind the Pfandbrief is in the important differences between the two forms of bonds. The vast majority of new issue volume in the Pfandbrief market over the last year has been in the public (öffentliche) sector rather than in the mortgage sector. As these bonds are backed by a pool of loans to the German public sector in the form of the federal and state governments as well as municipal authorities they in effect offer investors the same kind of security as bonds issued by the government itself. It is this level of security which has given rise to the use of the epithet “baby Bunds” to describe Pfandbriefe issues, which is a far more accurate description than the commonly used translation, “mortgage bonds”. More than 70% of outstanding Pfandbriefe in the market today are totally unrelated to mortgages, making this terminology a misnomer. Tailoring the Pfandbrief to international requirementsWith appreciation of the fundamental qualities and creditworthiness of the Pfandbrief having been established globally, the next key phase in the development of the market was to engineer technical changes in its structure in order to improve liquidity in the market and to tailor it more completely to the demands of international investors. The rise and rise of the Jumbo PfandbriefIn this respect 1996 was especially noteworthy for the progress which was made in the development of the market for Jumbo Pfandbriefe – the new name first assigned in 1995 to large scale issues typically of Dm1 billion or more. Jumbo Pfandbriefe are now also sometimes referred to as “liquid Pfandbriefe” as a means of distinguishing them from the less liquid issues of between Dm20 and Dm200 million which were the bread and butter of the sector up until the middle of the 1990s. The success of the Jumbo Pfandbrief market in its first full year is instantly illustrated in the primary market statistics for 1996. Total volume outstanding in the Jumbo sector of the market almost trebled in 1996, rising to Dm121.7 billion from Dm45 billion at the end of 1995, with an average of Dm6.4 billion of new issues launched each month. Last year was highly encouraging, however, not just because of the simple volume of new issues in the Pfandbrief market. A number of other developments also attested to its growing maturity and sophistication. One key breakthrough, for example, was the drawing up in March of a paper by the Association of German mortgage banks clearly establishing the definition of a “Jumbo” Pfandbrief and adding a number of recommendations to issuers aimed at further harmonization of the sector. Jumbo issues, this paper stipulated, must be worth at least Dm1 billion at issue, although smaller volumes are permissible for re-openings. Additionally, only straight Pfandbriefe carrying a fixed coupon payable annually in arrears and with a bullet redemption may be sold as Jumbo Pfandbriefe. Third and probably most important, in terms of liquidity, issuers of Jumbo Pfandbriefe must secure an undertaking from at least three market makers to quote two-way prices for the issue during usual trading hours. The issuer itself can be one of these market makers. Pfandbriefe issued prior to the drawing up of these rules in March 1996 can still call themselves Jumbo issues until their maturity as long as they conform to the size and format criteria outlined above, and as long as at least one institution undertakes to provide market making services. The six recommendations drawn up at the same time for Jumbo Pfandbrief issuers are for the most part technical guidelines aimed at bolstering and maintaining liquidity in the sector, although the sixth recommendation probably has the most far-reaching implications. This is that an issuer should take measures to facilitate the international placement of Jumbo Pfandbriefe. In effect, this implies that issuers should solicit investment grade ratings for their bonds from internationally recognized ratings agencies, without which many overseas institutional investors would be unable to buy Pfandbrief issues. The growing importance of ratings in the Pfandbrief sectorHistorically, Pfandbrief issuers which have found a ready-made base of local institutions ready and willing to absorb all new issues saw little reason to ensure that their bonds were rated, viewing the rating process as an unnecessary expense which made no difference to the marketability of their issues in the German market. The first signal of a reversal of this trend arose in 1987, when Frankfurter Hypo became the first issuer to solicit an international rating for its Pfandbriefe, being assigned a triple-A rating by Standard & Poor’s (S&P). Over the last 12 to 18 months, attitudes have shifted dramatically and new issues of Jumbo Pfandbriefe targeted to international investors are now frequently rated by one or more of the international ratings agencies. At the end of 1995 only two issuers had ratings for their Pfandbriefe. By May 1997 this total had increased to nine. As a result, last year 58% of all outstanding Jumbo Pfandbriefe had been assigned investment ratings. While the majority of these ratings are of the very highest rank, it is noticable that the ratings do vary slightly from issuer to issuer, and that in some cases there are even differences between the ratings assigned to public and mortgage Pfandbriefe of the same issuer.
Liquidity in the pfandbrief marketIn addition to the volume in the Pfandbrief market in 1996, however, another important feature of the year was the maintenance of strong levels of liquidity in the market, which has helped to diminish international investors’ long-held (but fundamentally erroneous) concerns that the Pfandbrief is an illiquid instrument. As a summary of 1996’s activity published by Deutsche Bank Research in February points out, “it was also good to see that not one market maker broke its promise to keep Jumbo Pfandbriefe liquid over a sustained period. Bid and offer prices are still quoted with spreads of 5 to 10 pfennigs depending on maturity for all Jumbos, including the very first, issued by Frankfurter Hypo in May 1995. Thus the Jumbo Pfandbrief market offers the investor far greater liquidity than, for example, the Deutschmark eurobond market.”
Going globalAside from being an important year in terms of volume and improvements to the structure of the market, 1996 was also a significant landmark because virtually for the first time in the history of the Pfandbrief market a number of issues were tailored specifically to international investors. DePfa Bank made significant headway in furthering international understanding of the instrument when it launched the first ever global Pfandbrief issue in January. This was a Dm2 billion seven year transaction which was sold in Eurobond form with Rule 144A provisions attached allowing for the bonds to be sold to qualified US institutional investors. With these global issues firmly establishing the “arrival” of the Pfandbrief as a truly international instrument, another issuer threw its hat into ring in June, when Rheinische Hypothekenbank which is owned by Commerzbank issued a Dm2 billion global Pfandbrief. In May 1997 Bayerische Vereinsbank and Rheinische Hypothekenbank told the public that they intend to issue a global Pfandbrief the following month. Also, Hypothekenbank in Essen and Frankfurter Hypo have announced they will launch global Pfanbrief issues later this year. 28 Market makersIt does not come as a surprise that the success of the Jumbo Pfandbrief market has also attracted the interest of the distributors. Currently 18 domestic and 10 foreign banks are active in this market as underwriters and market makers. The growing importance of the foreign investor community to the development of the Pfandbrief market is immediately visible in the 1996 league table of bookrunners for Jumbo Issues published by Pfandbrief Quarterly. Although the sector has traditionally been dominated by a small cluster of German banks, in 1996 three international banks appeared in the top 10, HSBC Trinkaus, with a total market share of 7.3%, UBS (5.0%) and Morgan Stanley (4.5%). Top of the table was Commerzbank, with a market share of almost 15%, followed by Dresdner Kleinwort Benson (14.3%) and Deutsche Morgan Grenfell (12.3%). The leader in placing Jumbo Pfandbriefe in the first five months of this year was Deutsche Morgan Grenfell (18.2%). Second came Commerzbank (16.9%), followed by Dresdner Kleinwort Benson (16.4%).
Encouraging developments in 1997If 1996 was a banner year for the development of the Pfandbrief sector, however, there were no signs of a let-up in the early months of 1997. On the contrary, with a benign interest rate environment pinning government bond yields down throughout Europe, the Pfandbrief sector was one towards which many institutions in search of security and yield gravitated in January and February. Issuers and lead managers in the sector were quick to pinpoint the strength of investor demand for the instrument. As a result, more than Dm16 billion of Jumbo Pfandbriefe were launched in the first two trading weeks of 1997 alone, comfortably outstripping issuance in the Euro-Deutschmark sector. In March new ground was broken with the first syndicated non-Deutschmark Pfandbrief issue led by Deutsche Morgan Grenfell (DMG) and Morgan Stanley with a Ffr2 billion deal for Frankfurter Hypo. This was the second time that Frankfurter Hypo had issued a Pfandbrief denominated in a currency other than deutschmarks, although its previous non-Deutschmark issue had been a private placement rather than a public transaction denominated in yen in July 1995. This issue incorporated a novel Euro-fungibility clause enabling the borrower to redonominate the bonds in euros after the start of the third round of Emu. Frankfurter Hypo’s strategy in launching a French franc-denominated Pfandbrief was to enhance the familiarity with the Pfandbrief concept among French institutions which invest primarily in French francs. In this respect the issue was a resounding success, with 95% of the bonds ultimately placed with French institutional investors whose portfolios are accounted for largely by securities denominated in local currency. Another critical breakthrough for the Pfandbrief market in March was the conclusion of an agreement between the main market makers in the sector and the Pfandbrief issuers on new placement procedures aimed at adapting the structure of the market and bringing it more in line with international practice. Features of this agreement included an undertaking to use the fixed price re-offer method in every new issue; to pre-announce all new issues at least three hours in advance of the launch, although the preferred notice period is one day; to benchmark every new issue to existing Bund or Bobl issues; and to incorporate a fee structure based on real rather than nominal fees of eight price basis points (bps) for five year deals and 15bps for 10 year issues.
The growing importance of foreign investorsIn total, it is now estimated that about 20% of the new issue volume in the Pfandbrief market is sold to foreign investors. While this total remains modest in comparison to overseas investors’ participation in the German government bond market, it represents a healthy advance, given that in the early 1990s foreign investors were reckoned to account for no more than 10% of the Pfandbrief market. Although precise figures detailing the ownership breakdown of Pfandbriefe are not yet available for the end of 1996, by the end of 1995 domestic institutional investors still accounted for more than 78% of the market, with insurance companies and pension funds holding 34.2% of all outstanding Pfandbriefe, banks accounting for 28.8%, investment funds for 8.6% and other domestic institutional investors (such as non-profit making organizations and public sector authorities) holding 6.8%. Retail investors accounted for 10.1% of the market at the end of 1995, leaving the balance of 11.5% in the hands of foreign investors. Conclusion and prospectsWhile Pfandbrief issuers and their bankers will justifiably argue that they have covered a colossal amount of ground over the last few years in improving the structure of the market and promoting it successfully overseas, there is also an awareness that there is no room for complacency, and that more needs to be done if the international popularity of the instrument is to be maintained and even grow further. One of the most frequent areas for debate in this regard touches on the absence of formal hedging mechanisms in the Pfandbrief sector, with Deutsche Bank’s Research department acknowledging in an issue of Pfandbrief Quarterly published in June 1996 that “an increasing number of participants are calling for the introduction of a Pfandbrief future in the near term. It is thought that with a functioning future, the Pfandbrief market could join the league of the world’s most attractive bond markets.” In the extensive analysis which followed, however, this bulletin argued that the Pfandbrief is not yet ready for a futures contract. Noting that the development of the market needs “more time”, this concluded that “the task for the moment is to further improve transparency and liquidity in the market to attract more, especially foreign, investors and to establish a sophisticated trading culture.” Clearly, the market and its participants have already gone a very long way towards achieving this goal. The Pfandbrief and EmuThe advent of the first round of European Monetary Union (Emu) on January 1 1999, is on balance expected to be a positive rather than a negative development for the Pfandbrief market. This is because convergence of European bond yields over recent months has reduced the scope for diversification by German institutional investors into higher yielding fixed income markets. Jumbo Pfandbrief bonds especially longer dated issues will therefore remain an attractive alternative for investors looking for a pick up in yield without sacrificing the quality of their exposure. No matter which currencies eventually participate in Emu, the Pfandbrief market will be the largest individual bond market in the union and the largest non-government market in Europe. It will also occupy a special position arising from the fact that all Pfandbrief issues will be eligible as collateral for Repo and Lombard facilities with the European central bank. This will make the Pfandbrief sector very well positioned within the Emu offering investors a wide range of product groups, ranging from traditional Pfandbriefe to structured instruments, floating rate bonds and Jumbo issues. |
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