IFR: Good afternoon and welcome to IFR’s fourth annual German SME funding roundtable. 2016 has been a volatile year for a host of reasons – sluggish growth, negative rates in Europe, a potential rate rise and forthcoming presidential election in the US, Brexit as well as several geopolitical flashpoints including the refugee crisis in Europe. Reinhard, to get our discussion going, can you help us make some sense of all the themes insofar as they have impacted markets and sentiment this year?
Reinhard Haas, Commerzbank: That’s an ambitious question but one thing I will say that’s different today from other cycles we’ve lived through is we have got used to a certain amount of permanent volatility. Prior to the financial crisis, any one of the events you mentioned would have caused major upheaval and a pause in capital markets issuance.
Every year for the past five or six years has had its flow of alarming stories. But when you are constantly subjected to news flow of that kind of magnitude, you get used to it. Astonishingly, market participants have shrugged off most of what we might have been expected to have led to volatile market conditions this year. To a certain degree, this has been fostered by the ECB’s policy of pumping liquidity into the markets and preventing them from reacting in ways they might have without such intervention.
Thomas Haas, BayernLB: The ECB has flooded the market with liquidity and as a result we have very low rates. That is driving the market at present. The dominance of this is so huge that political impacts are not hitting the market as much. Nobody knows how this will play out. The market is very liquid and is in very good shape at present but we are facing the fact that there is hardly any credit demand, especially among SMEs.
IFR: What’s the mindset of corporate treasurers at the moment and why isn’t there more loan demand? Corporates can raise money at rates they’re probably never going to see ever again. Shouldn’t they just raise the money now and stick it on the balance sheet so they’re ready for when the capex or spending cycle turns?
Johannes Hack, DZ Bank: To a certain extent, they have done exactly that. If you look at the cash balances of European corporates, certainly German corporates and particularly German SMEs, they are extremely liquid. They’re flush with cash and have extremely low levels of net debt even if a lot have refinanced and taken on additional debt.
But at some point you do need something to invest in ie, classic capex into technology, into manufacturing, into making things. That’s become a lot scarcer because [German] industry is already extremely efficient. Most corporates are basically where they want to be in terms of how modern their technology is, save for the public sector which I think is a different animal and worth investing in.
The only other thing you can invest in is M&A. There’s been a lot of M&A activity, which I think is a good thing. But while some of that has been successful, some has been slightly less so. People have taken that on board and are approaching M&A with increasing vigour these days but at the same time with caution.
Generally speaking, corporates are obviously very satisfied that things are working in their favour. They appreciate that banks are in somewhat of a difficult spot but at the same time they appreciate that they have a duty to their shareholders and their owners. Their first duty is to minimise their financing costs and they are taking advantage of that.
That said, there is a certain amount of discipline and a willingness by treasurers to say: “OK, I’m willing to accept something because I appreciate that it’s causing you pain as a bank” but broadly speaking they’re doing that on the back of extremely good times for themselves.
At that level it is extremely helpful to the banks because if we start looking at a scenario where we have low interest rates plus increasing loan loss provisions the banks are in an even tighter spot. Anything that is good for our clients is good for us.
Reinhard Haas, Commerzbank: On the issue of demand, corporates, especially SMEs, are not incentivised to raise debt if they don’t have a purpose for it. That’s different to earlier years where corporates raised cheap debt if they could, put it on the side and waited until they could use it. Now they are charged for deposits as a result of negative rates. The cost of carry hasn’t really gone that low because of that phenomenon so it doesn’t really work.
That said, the Schuldschein market has been growing tremendously: we have seen market volumes going up by more than 50% year-on-year; it’s a remarkable success story. Talking only for Commerzbank, half of our issuance now comes from outside of Germany. The SSD market is slowly internationalising but we have to keep in mind that it is still only a fraction in size of other debt capital markets instruments.
The reason these ideal conditions for SMEs to raise debt aren’t inciting more borrowers to borrow is that beyond issues of financing need, we have the adverse news flow I talked about earlier. Companies are feeling a lot of uncertainty, which makes them wary of long-term investments. They can raise money to buy other companies in order to enter another market but they don’t have medium-term visibility around whether it’s going to pay off or not so the general sentiment is not to enter risky territory and that’s holding them back from making more investments.
Enrico Miketta, LBBW: I slightly disagree with what Thomas said about the lack of demand from German SMEs. From a pure club deal or syndicated loan perspective, that is the case but there is still demand for strategic capex and M&A and an excellent base of funding sources, from factoring and leasing to Schuldschein and private placements.
In addition to that, the possibilities for German SMEs to finance investments abroad are increasing every day. Competition in the German market on the SME side is tough.
Martijn Kamps, ING: I don’t think the market has changed dramatically since IFR’s SME roundtable last year. We’re still in a low interest-rate environment. There is heavy competition and the demand/supply disequilibrium is still there. EMEA loan volumes are down year-on-year and there is a lot of M&A behind the activity.
But what is different to last year is that this low interest-rate environment is starting to have a real impact on corporates from a cost-of-carry perspective, and on banks too. It’s not causing any direct damage yet but with the run-off of loan books we’re close to seeing the real effects of the rate environment. That is the big difference compared to this time last year.
Johannes Hack, DZ Bank: We’ve already talked about the ECB. The really difficult part is not how long they continue doing what they’re doing but what happens when they stop. In this environment, the moment rates go up, a lot of savings and co-operative banks and borrowers will have huge problems. Their balance sheets will suddenly go topsy-turvy as bonds are marked to market. That’s massive. The question is: can the ECB stop doing what they’re doing without causing a big set-back?
Reinhard Haas, Commerzbank: They can over time. The Fed has shown how to do that; you can’t take major steps in too short a time because it would disrupt growth or even lead to a decline. No European government would survive such a drastic measure. And it would destroy second and third-tier banks if it was to continue without end.
Sandro Pittalis, NordLB: From an issuer perspective, this is a very decisive aspect. For SMEs that are able to issue bonds eligible for the CSPP, it’s quite easy to generate money at the moment due to direct and indirect effects of the programme. But once the CSPP stops and the ECB stops flooding the market, there will be a tremendous challenge for companies to restructure themselves and their corporate bonds.
Matthias Hellstern, Moody’s: The allocation of ECB funds might not be as appropriate as it seems since the issuers that are benefiting are big investment-grade rated companies that are barely paying any interest or in some cases actually receiving money to raise debt. SMEs are not benefiting. The market still differentiates very strongly in terms of creditworthiness. An SME with poor creditworthiness still has issues getting the financing it needs to finance its expansion.
Reinhard Haas, Commerzbank: That’s absolutely right. The pricing differential between rated and unrated bonds has widened over the last few weeks and is hitting close to 100bp. Few SMEs have a rating these days but in the German market they used to be able to raise debt at nearly the same levels as rated companies. At this point, that is not economically viable. There are possibilities around private debt that can compensate for a certain portion of that but a number of unrated SMEs are now considering going to the rating agencies to remedy the situation.
Thomas Haas, BayernLB: On the other hand, SME’s are profiting from what investment-grade blue-chip companies have achieved in their documentation. We have five plus one plus one maturities in the mid-cap sector with hardly any financial covenants. We also have tight pricing so a lot of elements you have in investment-grade blue-chip finance are shifting to SME financing in a spill-over effect.
Reinhard Haas, Commerzbank: The intention of the CSPP was to shift more financing to the debt capital markets and it was always stated that this was to foster extending credit to SMEs. But as long as you’re not publicly rated – which might not be economically advisable for smaller SMEs – the ECB programme does not really affect you.
I agree with Matthias: the impact of the CSPP has actually been to give easier access to money to companies that already had tremendous access to a very liquid market over the last few years. It doesn’t really add anything either to mid-caps, or even to large-caps that already had access where it has merely made the situation more pronounced.
Thomas Haas, BayernLB: I agree, especially the difference between rated and unrated bonds in the debt capital markets. But there are some routes that don’t play directly into the huge amount of money the ECB is investing in bonds. One is KfW, which benefits from the government rating and which is helping SMEs with [tailored] loan programmes, which offer an indirect way of helping SMEs in a way that is benefiting from ECB policy.
The second indirect route where SMEs have been able to benefit from the excellent market environment is through the Schuldschein market. If saving banks and Volksbanks are cash rich and are paying 30bp-40bp for deposits at the ECB, they have to invest so are searching for investment opportunities. In that regard, SMEs are benefiting indirectly from very favourable pricing due to ECB policy. But I agree that the bond market isn’t helping SMEs.
Johannes Hack, DZ Bank: If there is a 100bp rated/unrated differential that’s a lot but if on the other hand overall yields come down by 150bp, SMEs are of course still better off because they’re down 50bp. But what we’re seeing with loose monetary policy – and this is reflected in our margins on SME lending which have flattened where for a long time they were going down – is that from a credit perspective not all the pricing we’re seeing is warranted by the quality of the borrowers.
Reinhard Haas, Commerzbank: You make a very important point, which is the risk-return profile is inadequate. That eventually catches up with market participants. It is worrisome because if you lend money at a certain level of risk, the return must be in line so you can make the necessary provisions if things don’t turn out so well.
I don’t see an immediate problem; default rates across the industry are still at a very low level of around 2%. But when you look at the broader picture of why default rates are so low it comes back what Thomas said earlier: it’s probably a result of the loosening of structures. Whereas in earlier years you would have had discussions about potential default on the basis that borrowers had violated one or other covenant, for a lot of issuers those covenants have gone so it has become riskier in the long term.
IFR: I’d like to bring you in on that point Matthias in terms of default rates, credit structures and covenants.
Matthias Hellstern, Moody’s: Default rates have come up a little but from a very low level so it’s more a normalisation than anything else and they’re predominantly related to companies which are active in the oil and gas and raw materials sectors.
Apart from that it appears that even high-yield corporates seem to be doing relatively well as long as they’re not exposed to those sectors. You will always have defaults if companies are not well managed, have the wrong product or where there are technological shifts in their sector. But we don’t expect default rates to rise significantly.
On covenants, documentation structures have become weak and they remain weak. In the high-yield environment you still see revolving credit facilities that either don’t have any covenants or where covenants are only applied if the facility is 30% drawn, for example.
One observation I’d make, though, is that rated high-yield issuers, especially smaller companies, are typically not using the bond market any more. Most are using the term loan B market, which is the domain of CLOs and similar structures. That seems to be doing very well this year and we’ve seen a lot of companies using the term loan B instrument to refinance, and that is usually a privately-rated market.
Thomas Haas, BayernLB: Companies, not just in the term loan B market but investment-grade crossover companies too, are not thinking just about going to the public market or getting a rating; they’re tapping the Schuldschein market. Big companies too are stepping away from the public bond market to put Schuldschein in place because they can profit from a very flexible maturity profile and they don’t have to deal with ratings.
Nine of the 10 biggest Schuldschein in the market this year have been done by bond issuers and these days SSD are being issued to refinance bonds. The SMEs we are talking about would rather look to the Schuldschein market than opt for a benchmark jumbo bond.
IFR: Why is that? Is it purely a matter of price?
Thomas Haas, BayernLB: First of all, it’s price. Secondly it’s simply a decision by the CFO to avoid having to put a 100-200 page bond prospectus in place in favour of 30 pages of Schuldschein documentation. Thirdly, SSD is a standard product and you don’t need to fill the mouths of hungry relationship bankers. It fits perfectly into borrowers’ funding policies because they can very flexibly cancel or refinance.
Sandro Pittalis, NordLB: This is one of the reasons why the European Commission is trying to simplify prospectuses via the Prospectus Directive. Prospectuses are massive documents that take a lot of time and bear in mind you’re not just talking about drafting time; you also have to get them approved. There’s a big gap between the approval times at, say, the CSSF in Luxembourg versus BaFin in Germany. This is one of the reasons why the Schuldschein market is performing so well.
Martijn Kamps, ING: Thomas referred earlier to a spillover effect from the syndicated loan market from A to BB names and maybe on a case-by-case to crossover and sub-investment grade names. But the SME market in Germany today still depends to a large extent on bank financing. All we’re seeing is that other pockets (such as Schuldschein or Euro-PP) are becoming more interesting from the point of view of optimising the funding mix of corporates, and treasurers are better educated.
With more education, borrowers are able to look at the timing of their funding needs, tap into more niches and go for the right instrument. But those alternative sources are still very small and are not reaching into the SME segment we’re discussing today.
Matthias Hellstern, Moody’s: The arguments for Schuldschein aren’t all positive. You have an illiquid debt instrument and documentation that does not outline what happens in the case of default, plus investors in Schuldschein with potentially limited experience in capital markets. Given the high amounts that have been issued, you need to question whether the quality of issuers is going down. I fear we’re building a bubble that might burst at some point in time.
Johannes Hack, DZ Bank: That’s the key point about a lot of what we’re saying here. As investors look for yield they need to go down the credit curve. That’s the only thing they can do. A well-rated corporate no longer pays a premium so although it’s got a low probability of default, [it’s paying] a risk-free rate. Eventually over the cycle we’ll find that things are going to become itchy.
Enrico Miketta, LBBW: I’m not sure there’s a bubble in Schuldschein. Maybe we should ask if it’s the right product for borrowers however you define them in crossover territory and below; we’ve even seen Schuldschein deals that are structurally subordinated. But as long as you stick to the basics - companies that are investment-grade with regards to internal bank ratings and with stable cash flows - it’s a good product and investors know what they’re doing.
As Reinhard said earlier, we have seen an increase in the number of transactions and in volumes. There are two reasons for that. First, with regard to real SMEs, they are still first-movers who are refinancing historical capex and decreasing money held with core banks to gain some flexibility for further capex or M&A activity. That’s more than fair.
With regards to volume we have seen, as
Thomas said earlier, guys who can tap the bond market but who have decided for a couple of reasons to go the Schuldschein route. But I don’t think there is a bubble
Reinhard Haas, Commerzbank: If there’s a bubble I would look elsewhere, to developments in the leveraged loan market where the vast majority of structures today are covenant-lite. The market feels very toppy already, especially in the US, but we’re seeing similar signs in Europe.
Leveraged financings, which are riskier by nature, [used to] have covenants that would be breached but because they’re covenant-lite, this is not happening and it’s less visible. If economic collapse commences in these highly-levered companies it will come at a different level of magnitude than what we’ve seen before. This is where the bubble will burst rather than in the mid-cap or Schuldschein space, which neither have the volume nor are aimed at the risk profile of LBOs.
Martijn Kamps, ING: I agree with Reinhard that you typically won’t expect a bubble there. The majority of Schuldschein exposure that has been issued is unrated so we can always have a discussion about whether it’s investment-grade, crossover or sub-investment grade. It’s not being pushed too far into crossover areas yet so we still have decent names, reliable cashflows etc.
But if you think about the credit cycle you do see a lot of the loosening of structures, both in the syndicated loan market and in the Schuldschein area (which is typically an already very loosely structured product without covenants). You also see tenor distributions moving up to the longer end so as long as everything’s good we’re all fine, but down the cycle it might be different.
Reinhard Haas, Commerzbank: Schuldschein is generally a by-product of the overall financing of a company. You still have core banks setting up a core facility, usually in the form of a syndicated loan for many of the larger and some of the smaller SMEs.
If ever there was to be difficultly, economically speaking, in the performance of the borrower the core banks will come to terms with the company and try to figure out the situation and save the corporate from too much harm. That has really played out in the aftermath of the financial crisis, and probably helped to prevent damage.
Johannes Hack, DZ Bank: Which means we’re not getting paid now when things are good and we will be the ones to provide money when things are going badly, which for a bank is not such an attractive proposition.
Enrico Miketta, LBBW: I agree that Schuldschein is a by-product, so from an SME perspective, please don’t refinance your whole debt structure with it. Put in a syndicated facility or strong bilateral lines as core financing. And banks need to ask themselves whether specific clients are suitable for the Schuldschein product.
I can only speak for LBBW but one of our principles is to look at the credit and ask whether you would invest in it. If you wouldn’t, then maybe we don’t want to arrange a deal for the reasons that have been pointed out. As long as it’s a by-product and as long as it’s structured correctly with regards to no cross-default and better cross-acceleration, then as Reinhard said, the core banks will either find a solution or they won’t.
Reinhard Haas, Commerzbank: But we do see some very aggressive banks trying to promote the private debt product with companies that really don’t have the profile.
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|Corporate Schuldschein League Table (Jan 1 to Sept 30 2016)|
|Rank||Arranger||Pro Rata credit €m||Full Credit €m||No of Deals|
|11||Raiffeisen Bank International||302||820||4|
|Source: Thomson Reuters LPC|