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Schuldschein: a funding tool for our times?

13 March 2019
Richard Kemmish

Many of the defining characteristics of schuldscheine are in line with the zeitgeist of the financial markets. It’s no wonder that they are so popular. Ahead of the Euromoney Schuldscheine forum, my thoughts on what’s right about the market.


Some argue that the schuldscheine market is old fashioned, occupying a relic position half way between the bond and loan markets and that the inevitable market convergence which Capital Markets Union both signifies and causes will push it towards one of the competing models – bonds. The recent robust good health of the market suggests otherwise.

As an outsider but admirer of this market for many years I have always thought of it in certain ways: it has a less mechanistic, more nuanced approach to credit analysis, it is lighter and more flexible on covenants than the loan market, it is dominated by German lenders and it is an easier, if longer, process than getting a bond launched. All of these characteristics are increasingly important and in line with the zeitgeist.  Here are some reasons why:

Modellable risks are not the important risks

The bond market is pre-occupied with formal credit ratings. Since the crisis this has only got worse as ratings are hard coded into more and more regulations, laws and investment mandates. Which is odd really considering the credit ratings of the biggest casualties in the crisis – single A for Lehman and AIG, AAA for Fannie Mae.

Don’t get me wrong, I think that rating agencies do a great job. But their job is to consider those risks that are modellable. Non-model risks: sovereign intervention, technological obsolescence, regulatory change, fraud, fashion, cyber-crime, social activism, ‘black swans’ are increasingly more important than the inputs to rating agency models. Gerry Weber had a debt:EBITDA ratio below 2 when they last came to market; it shouldn’t have defaulted. 

Maybe I am being too generous to the schuldscheine market, but it does seem to have a less mechanistic, more nuanced approach to credits, in particular ‘story credits’ than the bond market.

Of course, there have been defaults of schuldscheine borrowers recently – not just Gerry Weber but higher profile names like Steinhoff and Carrillion. Each time an issuer defaults, journalists make a big deal about it being a challenge to the schuldscheine market. Each time, the schuldscheine market takes it in it’s stride. Perhaps it understands better that sometimes companies default, that’s ok as long as the risk is assessed and priced sensibly.

Execution risk is existential risk

Combine secondary market opacity with divergent views of an issuer’s credit and the job of the syndicate pricing a new issue becomes ever more difficult. Throw market volatility into the mix and the risk of failed public bond issues becomes very real indeed. For a cash rich, investment grade, corporate, so what? A pulled deal is embarrassing, but hardly problematic. For a lower rated issuer, without cash cushions and with heavy reliance on lenders rolling existing debt, a failed deal can become much more serious.

Call me a pessimist, but execution risk and the implications of a failed bond deal are only going to increase in the foreseeable future.

German civil engineering company Bilfinger recently showed that after a failed deal in the bond market, the greater certainty of execution available in the schuldschiene market is appealing. As GlobalCapital magazine put it Bilfinger ‘sought redemption’ in schuldscheine.

Marking to market is increasingly problematic

The securitisation market in Europe during the financial crisis was not taken down by waves of defaults, it was taken down by waves of mark-to-market. Similarly, banks funding themselves too much by the repo of bonds subject to revaluation clauses. In the first case, investor capacity to hold bonds was a function of what they were worth. In the second, repo counterparties got nervous about the value of the collateral.

Either way, good credits become bad credits when market values de-link from default probabilities. The more technical and regulation driven the credit markets become, the greater the risk that this happens. 

A lesson not lost on schuldscheine market participants.

Covenants need to be smarter, or less

As Owen Sanderson has rightly pointed out in GlobalCapital, simple (perhaps justified) changes to accounting rules – IFRS  16 on the capitalisation of leases or IFRS 9 on provisioning for future losses can radically change reported earnings. Covenants in loan documentation can easily be breached by a change in accounting policy.

Obviously, there is a trend towards financial covenants, particularly for longer dated schuldscheine, but, as with credit analysis, they tend to be more bespoke and better thought out. And if they are wrong, its easier to change a bilateral contract.

Germany is where the money (really) is

Bonds, loans, private placements, repos; wherever you look it’s been too easy to raise money recently. This isn’t the place to discuss the mismatch between the supply of and demand for funding or how the artificial liquidity in the system will go away one day, but away it will go. When it does, the markets that actually do have structural liquidity and high savings rates will be more important than ever.

There is a lot of talk about the internationalisation of schuldscheine, but that is internationalisation of borrowers and, to some extent, intermediaries. The investors, less so.  Just like the covered bond market, the schuldscheine market is a very effective, German-invented, and German-investor-friendly way to channel funds cross border.  

 

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