Germany 2005 - Warm welcome
Financing middle-market Germany provided the European high-yield bond market with a steady stream of business in 2004, and the same if not better flows are expected in 2005. As corporates turn away from the loan market because of changes to lending in anticipation of Basle II and the end of Landesbank guarantees, high-yield investors are welcoming the supply with open arms. Kate Haywood reports.
Traditionally, German companies have relied on cheap loan financing from local, state-owned banks. According to Goldman Sachs, 71% of corporate Germany's financing still comes from bank loans, while the capital markets account for only 29%. That compares with the UK, where only 10% of capital market financing comes from bank loans, or the US where the figure is 18%.
But the removal of State guarantees for Landesbanks in July this year, coupled with the more risk-sensitive capital requirements imposed by Basle II in 2007, are forcing Germany's domestic banks to re-assess the risk on their loan books.
Basle II proposes to raise the amount of capital that banks have to set aside for weaker credits and increase the need for sophisticated internal ratings mechanisms, meaning that cost of lending for banks, and a higher cost of lending for lower credit borrowers.
“Leveraged credits which used to enjoy lending terms of sub-Euribor +100bp are now seeing their cost of debt rising by at least 100bp–150bp,” said one capital markets banker.
This changing banking environment has seen domestic loan growth in Germany decline over the last three years, as banks scaled back their bilateral lending.
"With so many insolvencies going on in the last two to three years, all the German banks have become more restrictive and curtailed their lending," said Ralf Brech, co-head of global syndicate at HVB in Frankfurt. “There are now a small number that have begun lending again, but with nowhere near such aggressive terms as companies were used to. The banks have had to become much more selective because credit quality has become
increasingly important in determining lending terms.”
In contrast, the spread differential between high-yield bonds and the 10-year bond has shrunk significantly over the last two years. According to the Lehman Brothers’ pan-European high-yield index, average high-yield bond spreads fell to 266bp on February 28 2005, from 292bp on December 31 2004 and 399bp at the end of 2003.
In this climate of low interest rates, a more restrictive credit policy on the part of banks and the general economic downturn, high-yield bonds have gained in popularity among listed companies in Germany, and several have already moved to term out bank debt by selling new bonds. However, the market is still unattractive to most private companies as the disclosure and reporting demands required by the capital markets appear onerous compared to domestic solutions such as schuldscheine.
“The middle-market companies are comfortable with the demands of the high-yield market," said Edward Eyerman, senior director at Fitch Ratings. “In most cases they already prepare accounts in IAS and on a quarterly basis, they have investor relations departments and in general have adopted capital markets practices.”
Engineering group Jenoptik was one of the first German corporates to tap the high-yield market, with €150m of seven-year senior notes at the beginning of November 2003. That year, US$1.7bn equivalent of German issuance hit the European market, making up less than 10% of total supply. Since then, the number of small to mid-cap German corporates issuing high-yield bonds has risen more than 100%.
Last year, the market absorbed US$2.3bn equivalent of “quasi-opportunistic refinancings” from middle-market corporate Germany. Schefenacker, Duerr, SGL Carbon, Heckler & Koch, Gildemeister, Hornbach and Peri took advantage of the razor-thin pricing on high yield bonds.
“There has been a definite shift in the market. The German banks are getting less not more healthy, and some of the forward-looking companies have taken steps to de-risk financing structures by issuing bonds," said Mathew Cestar, executive director, high-yield capital markets at Goldman Sachs in London.
But despite last year’s encouraging volumes, observers are still waiting for the much-anticipated slew of deals that Germany could provide. So far this year mid-cap German companies have been relatively slow in coming to the market. Of the six German deals in the year to March 14, all but one have been sponsor-driven, however there is chatter about a number of corporate financings in the pipeline.
“You have to remember that accessing the high-yield bond market is not always the right option for some companies,” said Boris Funke, executive director, financing group at Goldman Sachs in Frankfurt. “In our conversations with these companies, they are much more capital markets orientated now than they were a few years ago, but they are also looking at semi-private instruments such as US private placements."
The growing need for companies to access the wider capital markets has seen new lenders break into Germany's domestic financing market for the first time. To this end, Germany's domestic banks are starting to examine the possibility of combining their lending and financing expertise and seeking closer collaboration with international institutions.
“Banks will increasingly have an interest in taking advantage of market windows along with executing their own banking strategy vis-à-vis lending,” said Jens Hofmann, managing director, financing group at Goldman Sachs in Frankfurt. “Commercial banks will investigate how to combine lending and financing expertise, and if they don't already have it, they will look at how they can build it. We think there is room for a model which combines traditional banking relationships with international banks' know-how and distribution, where a company mandates a German bank and an international bank to lead deals.”
In addition, some of the larger German banks such as HVB and WestLB are building up high-yield capabilities. Some that withdrew from the market in 2002 and 2003 are returning and, in an effort to retain their clients, are offering domestic market solutions such as schuldscheine – certificates of an underlying loan that is syndicated to multiple banks and even some investors – according to Fitch's Eyerman.
“In addition, they are offering subordinated debt and quasi-equity products specific to German accounting treatment called silent participations and profit participations,” explained Eyerman. “These may satisfy demands of senior lenders for more loss-absorbing junior capital while offering more flexible terms and attractive costs for borrowers."
The scope for higher quality issuers and portfolio diversification has seen investors greet the deals from German companies. So far though, demand has far outstripped supply.
“Deals that grow the market and are not LBOs are a good thing, because they provide diversification in rating and leverage strategy,” said Aengus McMahon, senior credit analyst at investment fund Insight Investment. “For a healthy market you can't simply have sponsor-lead deals alone; you need a good spread of issues and at the moment market issuance is clustered around B– and Triple C LBOs.
“My one concern is that a lot of these companies are used to direct banking relationships, and so most of them are not currently set up to give the disclosure needed for capital markets. But it is definitely two cheers for these companies coming into the market, and three cheers if they can sort out their disclosure issues."
There has also been strong demand for the recent brace of German LBO-linked, high-yield bonds, including deals for Almatis, Cognis, Celanese, Grohe, MTU, Dynamit Nobel and KDG.
This theme is expected to continue this year, when bankers predict that as much as a third of the market could originate in Germany. “If the recent trend continues, it is possible that issuance from German Mittelstand companies could exceed last year's levels by around15%,” said Goldman’s Cestar.
Although corporates are expected to provide a steady stream of supply, David Ross, director high-yield capital markets at Deutsche Bank in London, argues that most of the obvious candidates have all ready tapped the market.
“At present, most of the activity in Germany is sponsor-related, but I think we will continue to see a very steady flow of smaller corporates,” Ross said.
“In each year there have been a couple of one-offs: Heidelberg's €700m bond in 2003 or the €530m PIK from Cognis earlier this year, for example. But a lot of the obvious situations have already come and gone. Some of the existing issuers will have ongoing financing needs, but if they did a deal a year ago, they are not going to come back and refinance today just because rates have tightened by 100bp.”
And it is likely to be some time yet before private companies are tempted by high-yield.
“Hundreds of private, limited liability companies represent the true untapped potential for the high-yield market,” said Fitch’s Eyerman. “It’s about getting these companies comfortable with the fact that they may not be investment grade, and then letting them see that high-yield is increasingly a cheaper, more flexible and potentially more reliable long-term funding option.”