A EUROMONEY SURVEY - June 1996
AN ATTRACTIVE INVESTMENTIncreasingly - if belatedly - the international investment community is recognizing that the German Pfandbrief is an instrument which few institutions can afford to overlook. At the most basic level, the size of the market, with Dm1.258 trillion outstanding at the end of December 1995, means that the Pfandbrief now represents the third largest individual bond segment outside the US. Investors in the UK, for example, may be surprised to learn that the Pfandbrief market is now more than twice the size of the British government bond (Gilt) market. And while it naturally remains dwarfed by the US and Japanese government bond markets, the Pfandbrief sector is comfortably the largest fixed-income instrument in Germany, accounting for just under 35% of the Deutschmark bond market at the end of 1995. Federal government bonds, by contrast, account for just under 28% of the market.
YIELD AND SECURITYIts size apart, the Pfandbrief has historically been an important component of German institutional investors' portfolios because it has offered an enviable combination of yield and security.
Yield has come in the form of a generous pick-up over Bunds, which has ranged from between 20 to 60 basis points, and which has traditionally reflected the relative illiquidity of the Pfandbrief market compared with the government bond sector. Until the start of 1995, the vast bulk of Pfandbrief issues traded at identical yields. More recently, however, the emergence of the new Jumbo Pfandbrief market, offering investors liquid and transparent issues of between Dm1 billion and Dm5 billion, has led to the development of a two-tier market in terms of yield.
The yield differential between "traditional" Pfandbrief issues and the new Jumbo deals became especially pronounced over the first month of 1996, during which time the spread between Jumbo Pfandbriefe and Bunds narrowed sharply, from 25.6 basis points on January 2 to 14.2 basis points at the end of April. In a parallel development, the negative spread versus the swap curve and the yield curve for traditional Pfandbriefe both widened.
In spite of these recent spread trends, the double-digit yield pick-up over Bunds which the Jumbo Pfandbrief market offers investors remains highly attractive in view of its outstanding credit quality - a quality which many investors both within Germany and overseas are increasingly interpreting as ranking alongside the creditworthiness of the German government.
INVESTOR PROTECTION IS KEY
The unrivalled security of the Pfandbriefe is enshrined in the laws which govern their issuance and which are unequivocally committed to the protection of investors. Broadly speaking, investor protection is guaranteed at two levels - first, through the very clear legislation defining which institutions are privileged by law to issue Pfandbriefe; and second, through the equally clear and extremely conservative guidelines determining the quality and size of the collateral backing Pfandbrief issues.
Germany's Mortgage Bank Act (enacted in 1900) and its Public Sector Pfandbrief Act (passed in 1927) are the two laws which govern the issuance of Pfandbriefe, and under the terms of which issuance is strictly limited to four categories of German banks. These are the 24 pure private mortgage banks and the three mixed private mortgage banks (both categories are governed by the Mortgage Bank Act), the 12 regional Landesbanks and the six institutions which are classified as "public sector banks with special tasks" (governed by the Public sector Pfandbrief Act).
As of the end of December 1995, 55.2% of the Pfandbrief market was accounted for by private mortgage banks, with the remaining 44.8% the domain of public sector issuers.
THE SOLIDITY OF THE COLLATERAL
The collateral backing Pfandbrief issues takes the form either of loans made to the public sector (in the case of Öffentliche Pfandbrief) or of mortgages (Hypotheken Pfandbrief). Öffentliche Pfandbriefe, which account for over 70% of the total market, are fully collateralized by one large, separately registered pool of loans to, or guaranteed by, the public sector.
Given that under the German system there is a constitutional obligation for mutual financial support between the triple-A rated Federal government, the state and municipal governments and other public sector entities, it is self-evident that in terms of risk, the Öffentliche Pfandbrief market can be viewed as having a similar ranking as the German government bond market.
The fact that no Pfandbrief issuer (either of Öffentliche or Hypotheken paper) has ever defaulted, bears witness to the rock-solid security and creditworthiness of the instrument.
The collateral which backs the issue of Hypotheken Pfandbriefe derives its solidity in part through the ultra-conservative parameters which define its eligibility. Again, these bonds are fully collateralized by a single large, separately registered pool of mortgages on residential and commercial property. But mortgages eligible as pool collateral must not exceed 60% of a property's lending value, which equals an over-collateralization of 167%. Additionally, the valuation of the underlying property (lending value) within the collateral pool must be based on its permanent characteristics and on the income that can be earned from the property on a sustained basis, without taking the expected appreciation (or capital gain) of the property's value into account. As a rule of thumb, the lending value of eligible pool collateral has typically been between 10% and 15% below a property's actual market value.
MORE THAN A MORTGAGE-BACKED
For want of a more accurate official translation, non-German investors still frequently - but erroneously - assume that the Pfandbrief market is similar to the mortgage-backed securities market with which they are familiar in countries such as the US and the UK. In reality there are more differences than similarities between the two markets, meaning that ultimately investors will need to accept that the term Pfandbrief has no direct translation in the jargon of the international capital markets.
One of the most important differences between the Pfandbrief market and the mortgage-backed sector is that there is no link between any individual collateral within the collateral pools and any particular Pfandbrief issue. Specific assets within each pool are not segregated to cover individual Pfandbrief issues. In other words, if a Pfandbrief bank were to become insolvent, holders of Pfandbriefe would have first claim on the respective collateral pools in addition to recourse to any other of the bank's assets.
Another key difference between the two market sectors is that in the mortgage-backed market a special vehicle company (SVC) is set up and the assets are sold off-balance sheet. In Pfandbrief transactions the assets remain on-balance sheet. As a result, the issuing bank (rather than the SVC) remains fully liable for timely payments of interest and repayment of principal.
A third important difference is that the prepayment risk which is typical in the mortgaged-backed market is non-existent in the Pfandbrief sector.
JUMBOS HIGHLIGHT DIFFERENCES
The very clear differences between US-style mortgage backed securities and German Pfandbriefe have been graphically illustrated over the course of the last year, with the emergence of the new 'Jumbo' Pfandbriefe. The sheer size of each individual Jumbo issue - set at a minimum of Dm1 billion - has dictated that the vast majority of transactions in this new sector have been collateralized against loans to the public sector, rather than against residential mortgages. In this respect the name "baby Bunds", coined by non-Germans who find it difficult to pronounce the German word "Pfandbrief", is not too far off the mark.
By the end of April 1996, of the Dm83.5 billion of Jumbo issues which had been launched, Dm77 billion (close to 92%) was accounted for by Öffentliche Pfandbriefe. Of the 54 Jumbo bonds which had been launched by the same date, only four were classified as Hypotheken Pfandbriefe. In other words, the Jumbo Pfandbrief sector has almost nothing to do with the German mortgage market. Instead, an investor buying Jumbo Pfandbriefe will be gaining exposure to German government risk with a yield pick-up over Bunds.
JUMBOS ADD LIQUIDITY
The development of the Jumbo Pfandbrief market - which was kickstarted in May 1995 with a Dm1 billion issue launched by Frankfurter Hypo - has been critical for a number of other reasons.
First and foremost, it has injected substantial levels of liquidity into the market. In its special study of the German bond market, published in August 1994, Deutsche Bank noted that the typical size of a Pfandbrief issue ranged from between Dm50 million and Dm500 million, although traditional Pfandbriefe have also been launched in packages as small as Dm10 million.
In today's new Jumbo market, the average issuance size to date has been Dm1.52 billion. The largest individual issue so far has been the Dm5 billion Jumbo launched in November 1995 by DePfa.
JUMBOS BRING FOREIGN INVESTORS
A second critical feature of the new German Pfandbrief market is that its enhanced liquidity has clearly attracted the attention of international investment bankers and institutional investors.
At the end of 1994 (the latest date for which official figures are available), foreign investors accounted for only 11.7% of the total Pfandbrief market, which compared with a 45% holding of Bunds. At the same date, the lion's share of the market was accounted for by domestic institutional investors which held over 78% of all outstanding Pfandbriefe.
Today, it is believed that foreign holdings of Pfandbriefe are now much higher than the 11.7% recorded at the end of 1994. This is in part because an essential feature of the new Jumbo market is the placing of new issues via syndicates made up of between three and six marketmakers continuously quoting two-way prices.
Since September 1995, when Union Bank of Switzerland (UBS) was the first non-German institution acting as a joint bookrunner for a Jumbo Pfandbrief issue, international banks have been increasingly joining bookrunning syndicates.
In total, bookrunning by foreign banks accounted for 28.3% of the total volume raised in the Jumbo Pfandbrief market over the first quarter of 1996, compared with 15.8% for the whole of 1995.
In a reflection of the expanding role of foreign lead and co-lead management of Jumbo issues, the Pfandbrief Quarterly, a bulletin published by Deutsche Bank, has started to incorporate a regular league table of Jumbo issue bookrunners. In the first of these, published in April, Morgan Stanley came fourth, with Trinkaus & Burkhardt (a subsidiary of the HSBC Group) sixth, UBS eighth, and Merrill Lynch, JP Morgan and ABN AMRO 11th, 12th and 13th respectively.
THE PFANDBRIEF GOES GLOBAL
Morgan Stanley owes its elevated position in this league table exclusively to the important contribution it made to the development and internationalization of the Pfandbrief market in the first quarter of 1996.
This came in the form of its role as sole and joint lead manager (together with Commerzbank and UBS) of the two global Pfandbrief issues launched in February by DePfa which raised Dm2 billion and Dm1.5 billion respectively.
The international diversity of investor participation in both these issues speaks volumes for the new-found global acceptance of the Pfandbrief. According to DePfa, 19% of the two issues was placed in the US, with a further 28% taken up by Asian institutions.
Equally encouraging was that of the 53% bought by European investors, only 13% remained in Germany. The placement was carried out in accordance with usual market practice for global issues and included a pre-marketing as well as a bookbuilding phase.
Although the two DePfa global issues generated considerable excitement and press coverage both in Germany and abroad, they have not been the only landmark Pfandbrief issues to have made an important contribution to the internationalization of the market. Prior to the DePfa globals, the Dm3.5 billion issue launched in January by Hypothekenbank in Essen had been the first Jumbo Pfandbrief to have featured standard Eurobond syndication and fee structures, with six joint bookrunners and a selling group of 16 institutions.
Later in the same month, Bayerische Vereinsbank issued the first Jumbo Pfandbrief to have been placed via a syndicate using the fixed price re-offer method. This 10-year Dm1.5 billion issue, which was co-led by Bayerische Vereinsbank, Commerzbank, Merrill Lynch and UBS, was also the first Jumbo to have been priced against a benchmark Bund issue.
Although in its first 10 months the Jumbo Pfandbrief market grew with breathtaking and unexpected speed - with total outstanding volume breaking through the Dm50 billion mark by January 10 1996 - few market participants believe that this level of new issue activity can be maintained over the coming year, for several reasons.
First, a hazier macroeconomic and interest rate climate is already suggesting that 1996 is unlikely to be as prosperous a year for European bond investors as 1995.
Second, Germany's mortgage bank sector can only issue new Pfandbriefe in volumes which are proportionate to the increase in its new lending. Finite demand for new lending in Germany translates automatically into a finite supply of new Pfandbriefe.
Be that as it may, it is self-evident that the Jumbo Pfandbrief market is here to stay. Even assuming a gradual deceleration in the level of new monthly issuance of Jumbo Pfandbriefe (from between 20% to 30% in the latter months of 1995 to between 7% and 10% in mid-1996, and 5% to 6% by year-end 1996), it is expected that by the end of this year the total volume outstanding will be in the neighbourhood of Dm130 billion - which would equate to about 10% of the entire Pfandbrief market (traditional Pfandbrief and Jumbo issues combined).
A STANDARDIZED DEFINITION
To support the long-term transparency of the Jumbo Pfandbrief market, a standardized definition of the term 'Jumbo' is imminent. Only issues with a minimum size of Dm1 billion, which are in the form of straight bonds (as opposed, for example, to FRNs), and which have at least three marketmakers permanently quoting two-way prices will be allowed to market themselves under the Jumbo banner. A 'Grandfather' clause will, however, enable existing issues of Dm1 billion or more self-led issues with the issuer being the only marketmaker, to continue to be referred to as Jumbo Pfandbriefe.
JUMBOS PART OF A LARGER PLAN
In spite of the obvious success of the Pfandbrief Jumbo market to date, it is a mistake to view the developments in the Jumbo sector in isolation, or as a one-off move to enhance volumes, liquidity and transparency. It is more accurate to interpret the evolution of the Jumbo market as an essential component of a much broader mosaic which will continue to be enhanced and developed in order to underpin far-reaching support for the market, both domestically and overseas.
Encouraged though they have clearly been by the early success of the Jumbo market, German bankers are sufficiently realistic to acknowledge that its launch coincided with an especially benign environment for the European fixed-income market. As a result, they are equally aware that the Pfandbrief market needs to be developed further, in order to provide it with a number of essential safeguards to protect it from any long-term turbulence in the bond market.
Many of these initiatives have already been made. A Pfandbrief index (the PEX Index) has been launched, re-based to 1988 and offering investors a more efficient means of tracking the performance of their Pfandbrief holdings.
More recently, in December 1995, a computer-based bond-trading system, IBIS-R (modelled on the IBIS system which has served the German equity market so well), was also launched, which was viewed as a further important step towards bolstering secondary market liquidity in the Pfandbrief sector.
GROWING DEMAND FOR RATINGS
Another critical recent development in the Pfandbrief market - and one which bodes well for its rapidly expanding global acceptance - has been the growing demand for internationally-recognized investment grade ratings among the leading Pfandbrief issuers. Although the senior unsecured debt of many of these banks have enjoyed long-standing and prestigious ratings from agencies such as Standard & Poor's (S&P), Moody's and IBCA, until very recently only one Pfandbrief issuer (Frankfurter Hypo) had secured a rating specifically relating to its Pfandbrief issues. Over the course of the last year, a number of other major issuers in the market - including Bayerische Vereinsbank, DePfa, Lübecker Hypothekenbank and the Commerzbank subsidiary, Rheinische Hypothekenbank - have all followed suit, each securing triple-A (or equivalent) ratings on their Pfandbriefe. As more issuers seek to broaden their investor base still further, it is to be expected that the number of banks issuing rated Pfandbriefe will continue to grow.
INNOVATIONS IN THE PIPELINE
Looking to the future, a number of other innovations are expected in the Pfandbrief market, which will further enhance its international standing by bolstering liquidity and attracting a more diversified range of investors. These include the emergence of a Pfandbrief repo market, options on Pfandbrief issues and, ultimately, the introduction of a Pfandbrief futures contract.
Bankers believe that a Pfandbrief future would most likely be modelled on the existing five year DTB Bobl future, and that only triple-A rated Jumbo Pfandbriefe with a remaining maturity of between three-and-a-half and five years would qualify as deliverable paper for a futures contract.
Analysts at Frankfurter Hypo believe that an underlying volume of deliverable paper of between Dm70 billion and Dm80 billion would be a prerequisite for the establishment of a well functioning five-year Pfandbrief contract.
Although the total volume now outstanding which would be eligible for delivery in accordance with these parameters stands at Dm32 billion, it is anticipated that, if the market continues to grow at or near current rates, an adequate volume of deliverable paper could be built up within the next two years.
A PIONEER IN THE MARKET
The newly named Frankfurter Hypothekenbank Centralboden (FHC or Frankfurter Hypo for short) came about as a merger in 1995 which joined Frankfurter Hypothekenbank and Deutsche Centralbodenkredit. A subsidiary of triple-A rated Deutsche Bank, who own 95% of the company, the new FHC entity is the second largest private pure mortgage bank in Germany in terms of assets, with total assets of Dm76.1 billion and total equity of Dm2.2 billion.
Prior to this merger, the old Frankfurter Hypothekenbank had always acted as an important pioneer in the Pfandbrief market, making a key contribution towards the internationalization of the instrument. In 1987, the bank was the first in Germany to secure a triple-A rating on its Pfandbrief issues from Standard & Poor's, and, more recently, it was the first to launch a Jumbo issue. By the end of May, 1996, FHC had launched four Jumbo Pfandbriefe with a total volume of Dm4.5 billion.
FHC's mortgage collateral and public sector loan pools are well diversified. At the end of December 1995, its property collateral was valued at Dm27.6 billion, accounted for by almost 100,000 individual loans widely dispersed among 16 German Länder. On the same date, FHC's total public sector loan pool was valued at just under Dm35 billion, 100% of which was accounted for by domestic loans.
Growth of Pfandbriefe outstanding since 1980
Growth of the Jumbo Pfandbrief market
Pfandbrief: third largest bond market outside US
Total gross sales of Dm bonds
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