By exploiting investors’ flight to quality during the eurozone crisis years to stretch maturity profiles and bring down net borrowing needs, German regions are slowly relaxing their gross funding targets.
State of North Rhine-Westphalia — the largest issuer among the German regions, or Länder — is typical of its peers in having a slightly reduced funding target of €20.5bn this year, from €22bn in 2013. But despite the reduced needs the issuer sees greater challenges ahead in 2014 than last year.
“Spreads are very tight — some of the Länder trade inside mid-swaps even for benchmark tenors,” says Axel Bendiek, head of funding at Land NRW in Düsseldorf.
“Interest rates are very low, so combined this means investors really find it hard to hit yield targets. At the same time there is enhanced competition from eurozone sovereigns like Spain, Ireland and Portugal — the markets have been very constructive for them and their paper has performed well.”
The tight pricing could also make life difficult for Germany’s agencies.
“This is actually a challenge for issuers like KfW with a refinancing volume of around €65bn yearly,” says Jörg Müller, head of origination for Germany at DZ Bank in Frankfurt.
“Rentenbank, with a funding volume of around €11bn, will find opportunities to get good funding windows and to meet their funding levels. KfW’s funding mix will not change with regards to their funding volume and investors’ appetite for higher yields. There is some flexibility to give up a few basis points on their benchmark transactions.”
Horst Seissinger, head of capital markets at KfW in Frankfurt, is confident the agency can meet the challenge. He also believes that KfW’s peers — like Rentenbank, which received a full state guarantee this year — are enjoying strong demand.
“One of our major targets is to minimise funding costs and so far we have been successful,” he says. “Many market participants were surprised, though we were not, that after Rentenbank received its explicit guarantee its attractiveness has increased considerably. Investors naturally have an interest to diversify.”
Other bankers agree that there should still be plenty of demand.
“Investors in general are interested in increasing the running yield in their portfolios — and not to be underweight against their benchmarks in decent yielding credits,” says Achim Linsenmaier, joint head of European SSA syndicate at Deutsche Bank in Frankfurt.
“Obviously there are differences between the various investor types. For example, real money accounts are very much focused on total return — they are currently buying a lot of the periphery paper. Banks are under pressure to increase net interest margins while they have pretty big restrictions on risk weighting at the same time. In this environment, agencies like KfW or Rentenbank are assets that a lot of the German banks like buying as liquid assets for the liquidity coverage ratio. This creates a good bid for the agencies. Obviously in this environment — with the aim to improve net interest margins — there is a lot of price sensitivity, especially the further one moves into sub-Libor territory.”
Arbitrage lost
Other changes in the market outlook are due to basis swap rates. The euro/dollar cross-currency basis swap — which was deep in negative territory during the crisis, offering incredible arbitrage opportunities for strongly rated euro funders to print in dollars — has floated up to around the zero mark.
While the Länder typically do not focus much on dollars, the loss of the arbitrage opportunity could shift how German agencies approach the market.
“The significant move in the euro/dollar basis swap over in the past two years has gradually been removing some of the attractiveness of the dollar market funding available to issuers compared to levels achievable in the euro market,” says Deutsche Bank’s Linsenmaier.
One example is KfW. While the issuer will maintain a benchmark presence in dollars, the currency’s share of its issuance is likely to decrease this year.
“Around 55% of the €22bn we have raised so far this year has been in euros,” says KfW’s Seissinger. “That trend will probably increase. The cost advantages of printing in dollars and other currencies have declined.”
But KfW is finding increasing demand in other areas. In just the first quarter of 2014, it has printed around €720m of Uridashi, compared to €1.8bn over the whole of 2013. It’s a similar story in yen denominated medium term notes for institutional investors, where the issuer has raised ¥8bn ($78.1m) across 30 transactions, compared with ¥13bn in more than 40 deals in 2013.
“We believe that Japanese investors — especially in the retail sector — are really interested in our products and this is because of the generally positive market tone and KfW’s good name recognition,” says Seissinger.
“A lot of that demand has been for Uridashi linked to currencies or the Nikkei index — that is currently dominating the market.”
However, changes in basis swap rates are also creating more competition for some German issuers. With the euro/dollar basis swap rate reaching parity, it creates avenues for traditional dollar funders to print in euros.
“Other competition comes from European agencies that have excellent credit quality but can offer a wider spread than us,” says NRW’s Bendiek.
“Some of the Scandinavian agencies are considering euro benchmarks — either for the first time or the first time in a long time — because of the cross-currency basis normalising. That will enhance competition.”
Flexibility
The ability to be flexible has been key to regions’ funding plans.
Bendiek at Land NRW believes the political turmoil in eastern Europe, where Russia has annexed the Autonomous Republic of Crimea, and concerns over a slowdown in Chinese growth could once again augment Germany’s safe haven status. But worried investors’ cash is more likely to flow straight to the German sovereign — meaning smaller issuers need to be creative to attract money.
“The regions should really focus on their comparative strengths — their flexibility to easily cater to specific investor needs,” he says.
“They are flexible on product and maturity, can issue floating rate notes and play the whole spectrum of tenors up to 20 years, 30 years or even more. We can issue foreign currencies and structured notes. The German government can issue foreign currencies but it has an issuance calendar that is pretty much predetermined so it’s harder for them to react to developments in the market.”
Land NRW showed its flexibility with a debut New Zealand dollar trade — a NZ$50m ($41.3m) January 2016 floater — in January, but has more plans in store.
“We always do callable deals — there is always demand,” says Bendiek. “We’ve had demand for inflation linkers and zero coupon structures, although we’re not quite in the position to issue yet. We don’t print credit-linked structures but apart from that we have a wide range we can offer, provided we can get swaps in place — which usually isn’t a problem.”
Clubbing together
While large, established issuers like Land NRW can be smart and sophisticated, small German regions and cities would also like to gain access to the market — and by being innovative, they have done just that.
Six German cities in NRW — Dortmund, Essen, Herne, Remscheid, Solingen and Wuppertal — clubbed together to issue a €400m bond in February 2014. In 2013, the cities of Nürnberg and Würzburg raised €100m with a similar deal. More cities are expected to follow suit.
“German cities’ issuance will become more important in the near future,” says Mike Richter, executive director at DZ Bank in Frankfurt.
“Joint issues are a logical choice for smaller public sector issuers to get capital market access. But they have to do a lot of homework to be fit for this new world. The success of transactions also depends on the city’s credit and its region. The Würzburg/Nürnberg joint issue was a great success, while the joint issue of the NRW cities was not such a success. They planned to issue €500m but in the end could only issue €400m.”
The “new world” Richter speaks of is part of a trend across Europe, where regions that used to rely on bank lending for cash are having to turn to the capital markets.
“These days banks are increasingly under regulatory pressure to reduce leverage and increase capital ratios,” says Deutsche Bank’s Linsenmaier.
“Therefore most of the banks have less interest in lending compared with six or seven years ago. Back then, German Landesbanks and mortgage banks, for example, were extremely active in the public sector lending business. It seems like Landesbanks are these days significantly more focused on their home markets again. Also, the business model of most of the mortgage banks has changed — some have disappeared, while others focus mostly on the mortgage business. For the states and cities this means that a lot of the competition has disappeared and terms might just be less favourable.”
But some of the regions have regulatory worries of their own. The Basel Committee has yet to confirm whether Länder will be classed as Level One assets under new liquidity coverage ratio rules. If they are not, it could limit banks’ desire to buy their paper.
“We believe we are Level One assets but it’s not in writing yet and has been disputed,” says NRW’s Bendiek. “Investors need a clear commitment on this.”
But on a positive note, the larger Länder have been able to take advantage of a new source of funding. In June, the first ever joint German government and region deal — dubbed Bund-Länder-Anleihe — offered enticing pricing for the issuers involved. The deal is not guaranteed by the state, but each issuer is liable for its portion of the proceeds. Richter at DZ Bank would like to see more — and so would issuers.
“The Länder would be prepared to be part of the deal but it’s for the federal government to decide,” says NRW’s Bendiek. “Economically they are interesting because the spread was very tight compared to regular Länder issuances and it makes sense because the federal government and the Länder share important credit fundamentals, due to the federal equalisation scheme [a system to ensure the German federation and Länder share funding appropriate to their relative wealth].”
