What's hitting the headlines in Germany's credit market?

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Throughout October, Germans have been flocking to cinemas to watch A Summer Fairytale, a feature-length documentary telling the story of this year's football World Cup when, during six heady weeks in June and July, the German team stormed to the semi-finals and united the nation in footballing fervour. Screenings of the film in the Wiesbaden area have almost certainly been attended by the treasury and finance team from industrial gas giant Linde, who spent most of the tournament stuck in the office as they sought to finalise the structure of a daring EUR1 billion-plus hybrid bond.

“My team is very interested in football, but all they had was a little TV set in the corner of the room,” says Erhard Wehlen, Linde’s treasurer in Wiesbaden. “Instead of watching the tournament with friends and family, they were sitting in the offi ce every night waiting for answers to come back from the rating agencies in New York. They did an outstanding job.”

Hybrid bonds have been the big story in Germany’s corporate debt markets over the last 12 months. They get their name from the fact that they combine aspects of equity – employing a very long-dated or perpetual structure and making coupon payments conditional on fi nancial performance – with more typical debt market conventions.

Hybrid issuance is still just a small slice of a German corporate bond market that has racked up €85 billion in issuance this year as of mid-October. But hybrids are expected to become a more prominent feature of the German market. Of 18 outstanding European hybrid issues dating back to June 2003, nine have been launched by German companies since the summer of 2005, with borrowers as diverse as family-owned mail order group Otto and blue-chip industrial giant Siemens getting involved. During the same period, there have been two issues out of France and one each by companies from Sweden, Denmark, Italy and the US.

On a knife edge

The Linde transaction was more important than most, partlybecause the near-term prospects for this nascent market werehanging in the balance at the time of the deal’s launch. The dealcame to market on July 7 following a period of intense volatilitysparked by the stock market sell-off in May and June. Everythingfrom high-yield bonds to emerging market assets was affected,including the entire crop of outstanding hybrid issues. Onehybrid – Henkel’s €1.3 billion issue – traded out to 121 basispoints over its original spread of 185bp. There were suggestionsthat the volatility had dealt the market a paralysing blow.

“A sell-off in a mature market and an immature market are two different things,” says Andreas Schlotter, head of corporate origination for UBS in London. “In an immature market, people always wonder whether the market is dead, whether investors will ever return. The Linde transaction re-opened the market. They were brave. They took the plunge and they were successful.”

It’s appropriate that Linde should be the company to re-open Europe’s hybrid debt market because it was also the fi rst to issue a hybrid bond in June 2003, and is now the only European corporate to have issued two hybrids. The success of this summer’s issue emboldened investors to return to the market. Spreads were already coming in when the Linde deal was launched but since then they’ve tightened dramatically, and other issuers have taken advantage. In September, Siemens and General Electric launched their own hybrids and both copied one of Linde’s innovations by splitting the bond into two tranches: one euro-denominated and one sterling-denominated tranche for UK-based investors. Ironically, these three deals – brought to market by two German companies and one American firm – account for the only sterling- denominated corporate hybrid debt available.

With the summer storms safely weathered, market participants anticipate further issuance. “It’s definitely a sector we expect to expand over the next 12 to 18 months,” says Andreas Römer, head of investment-grade credit for Europe at DWS Investments in Frankfurt. But what is driving the emergence of this new form of financing – and why has it been embraced by German issuers in particular?

Twin virtues

Hybrid bonds have two fundamental attractions for issuers: first,they help support a company’s credit rating by occupying thepoorly charted territory between debt and equity, and second,they’re relatively cheap.

The rating agencies count a percentage of hybrid debt as ‘virtuous’ equity, rather than ‘sinful’ debt which weighs on the balance sheet and can drag companies towards a lower credit rating. Consequently, when a company needs to raise a lot of money – for an acquisition, say – balancing debt with equity in the form of a hybrid bond helps it to keep an even keel.

German companies have been very acquisitive recently and this helps explain the popularity of hybrid instruments, notes Alex von zur Mühlen, co-head of client coverage in the German global markets team at Deutsche Bank in Frankfurt. Bayer, Siemens and Linde financed M&A deals through hybrids.

Equity credit also explains why hybrids can be cheaper than other alternatives. Take a hypothetical situation in which a company needs to raise €1 billion while protecting its credit rating. A €1 billion hybrid with 50% equity credit would synthetically create €500 million of equity. The company could also achieve the same effect by launching two traditional equity and debt issues, each for €500 million. The effect of the two issues on the balance sheet would be the same as the €1 billion hybrid, but while the hybrid is fully tax-deductible, the alternative route would require the issuance of fresh equity which would not achieve the same tax savings.

As UBS’s Schlotter explains, the hybrid creates synthetic equity more cheaply than the company could issue ‘real’ equity. Assuming certain tax rates and a moderate level of volatility for the company’s stock, the difference between the two financing options in Schlotter’s example is more than 200 basis points. “The kicker in all of this is that the equity-generating hybrid structure is tax-deductible. The value comes from that tax shield,” he says.

But there are also local reasons for German companies to be attracted to hybrids. The country’s corporate ownership culture remains very conservative. Many firms still have substantial cross-shareholdings in other companies and occupy seats on each other’s supervisory boards. Others are either wholly owned by their founding families or have sizeable family involvement. Equity is anathema to these long-standing interests because it dilutes their returns and their control.

“If a company wants to raise finance and protect its rating it could issue equity, but that creates dilution which is not what shareholders want and is also expensive,” says Von zur Mühlen. “In the current rate and spread environment the cost of borrowing is at historic lows and if you can create synthetic equity without actually issuing equity – well, that looks very attractive.”

A mezzy business

Similar kinds of arguments have helped drive another trendpeculiar to Germany, the emergence of a new €3 billion-plusmezzanine finance market which enables small and medium-sizedcompanies to access capital markets funding via the securitisationof so-called ‘participation rights’. Known as Preps (preferredpooled shares), the financing platform was launched in 2004by an Austrian-based structuring boutique, Capital EfficiencyGroup, in conjunction with Hypo-Vereinsbank (HVB).

The first three Preps transactions were completed by HVB during 2004 and 2005, before rival institutions began muscling in on the action. Today, at least five different securitisation platforms have closed deals with a sixth hoping to launch soon; but the market is getting increasingly crowded and investors received a wake-up call this summer when one habitual user of mezzanine finance turned out to have been cooking its books.

German toymaker NICI paid €28 million for the sole merchandising rights of ‘Goleo’, the tournament mascot for the 2006 Fifa World Cup. But the firm scored a spectacular own goal when it filed for bankruptcy protection in mid-May after the expected avalanche of orders didn’t materialise. An investigation later revealed accounting fraud on the part of the firm’s owner, who claimed that he was trying to protect the 500-odd staff of the Mittelstand company.

NICI’s problems made headlines across Europe and dragged three mezzanine finance platforms into the spotlight as well. The company had raised a total of €40 million in capital using the platforms according to one industry source. Standard & Poor’s, which rates the Deutsche/IKB and Commerzbank platforms, quickly affirmed the former but put the latter on negative rating watch, says Viktor Milev, a rating analyst in the structured finance group with S&P in Frankfurt.

Germany’s mezzanine platforms work by using equity-like ‘participation rights’ from a pool of Mittelstand firms to back a securitisation. Like hybrids, the deals are deeply subordinated debt that allows borrowers to defer coupon payments. By grouping many companies together, the platforms funnel money from capital markets investors to companies too small to be able to tap the markets on their own.

Happily in debt

It’s an innovative solution to a particularly German problem.Like their bigger corporate counterparts, Mittelstand firms tendto favour debt financing over equity because it doesn’t weakenthe existing owner’s grip on the company; but the impendingarrival of Basel II is expected to make credit harder to come byand more expensive. Germany’s Mittelstand needed to bridgeits equity gap.

Capital Efficiency Group and HVB stepped into the breach with the Preps financing platform. The first deal raised €249 million for 34 companies. The second raised €616 million for 67 companies. HVB’s competitors were initially caught cold and it wasn’t until the middle of 2005 that HSBC’s German subsidiary closed a deal on a rival platform.

Since then, Deutsche Bank (in conjunction with Deutsche Industriebank, or IKB), Commerzbank, and WestLB have also closed deals, while HSH Nordbank together with Landesbank Baden-Württemberg is also hoping to close a much-delayed transaction. Preps, meanwhile, hopes to bring its sixth transaction to market later this year.

NICI had raised €10 million in each of two deals printed by the HVB platform. It had raised another €10 million in the Deutsche Bank/IKB deal and the same amount in the Commerzbank deal. The Commerzbank deal was the problematic one. S&P concluded that the transaction could withstand a 15% net loss in the event of a NICI default and – lo and behold – Commerzbank managed to find a buyer for the NICI exposure who paid 85% of the notional value late in July.

Reports at the time suggested that Commerzbank had sold the exposure to itself in order to protect the deal’s credit rating, notes one market source. Regardless, says S&P’s Milev, the sale crystallised the amount recovered. “At that point, we could model the data – and we were able to affirm the transaction,” he says.

It was an uncomfortable period for the mezzanine platforms. “For a couple of weeks it was all over the press. Everyone was talking about it and we got a lot of calls,” says Andrea Gutermuth, associate director at S&P in Frankfurt. That hasn’t scared people away, though. “Investors and arrangers have not shied away from these transactions. The pipeline is still full, which suggests confidence in the rating methodology.”

Bad taste

But the NICI affair has also stirred up some ill feeling amongthe mezzanine platforms. A senior executive at one of three firmsinvolved in the NICI episode claims that the company had triedto tap the platform for further capital, “but we turned themdown. They were full up with mezzanine. Then they turned upin other deals.

” This is a symptom of an increasingly overcrowded market, he complains. The heat of competition is driving some platforms to subsidise their deals and lower underwriting standards. “That’s great for companies because it means you can fund yourself at very good prices,” says the executive, “but is there enough money here for arrangers and intermediaries?” That’s a question which will become clearer over the next year or two.

Germany’s adoption of hybrids and innovative mezzanine instruments is unusually forward-thinking and flexible for a market which has traditionally been seen as somewhat conservative. So how supportive have investors been? Recent deals have been oversubscribed but Axel Potthof, head of European high yield at Pimco in Frankfurt, says that the hybrid market still has a lot of growing up to do. “There is no real, established investor base,” he says. “The high-yield guys don’t look at it, and it’s too risky for many of the investment-grade guys.” Still, the liquidity available in the bigger issues has encouraged Pimco to buy into select deals: Potthof cites the Lottomatica and Henkel transactions as ones that the firm liked.

Other investors have been wary because of the lack of standardisation in hybrid issues. “They all have different languages, different structures and different options to defer coupons,” says DWS’s Römer. As a result, investors can’t just analyse the credit fundamentals of the underlying company and weigh up the expected returns, they also have to pull apart the structure.

The differences between the deals can be seen most clearly in the triggers that compel companies to defer payments to investors. According to Jörg Patzenhauer, head of debt capital markets for Germany, Austria and Switzerland at Dresdner Kleinwort in Frankfurt, investors in the Bayer hybrid will see their coupon payments mandatorily deferred if the company’s consolidated gross cashflow dips below 7% of the company’s consolidated sales revenues.

By contrast, a bond issued by Italian lottery operator Lottomatica will defer payments if the company’s free cashflow before debt service, divided by interest expense is less than or equal to 1.35. The Siemens issue uses a similarly complex formula depending on free cashflow and interest expense. The amount of homework required means that “not all investors are stepping in straight away,” says DWS’s Römer.

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Structured credit and derivatives make progress

Along with the hybrid and mezzanine boom, the local market forstructured credit and credit derivatives has also been growing. Thenew sophistication of the local credit market is illustrated by thelaunch of products like DWS’s Invest Corporate Spread Dynamic,the first German credit fund to be focused on derivatives, saysRömer. The idea is to use index swaps and single-name creditdefault swaps to take both long and short positions on any of theroughly 1,000 investment-grade companies that are followed bythe firm’s analysts globally.

Since its launch in February, the fund has attracted €175 million of investment. Römer explains that the fund is designed to be flexible enough to cope with variations in market sentiment. “When risk premia are low, as at present, there are good reasons to stay long credit,” he says. “But there’s a chance that we’re going to see a more bearish environment for credit emerge over the next few quarters and we wanted a product that also had the flexibility to have an outright short position in these situations.”

In the structured credit arena, around €6 billion of collateralised debt obligations had been launched by mid-October, versus €8.3 billion for the whole of 2005 (see chart). However, enthusiasm for CDOs has not always been high. The market took a big hit in Germany when losses and downgrades cut a swathe through the late-1990s vintage issues, says Pimco’s Potthof.

Then, as investors were recovering their interest, a highprofile dispute erupted between HSH Nordbank and Barclays in September 2004, with the German bank alleging that Barclays had stuffed a CDO full of toxic credits. A $151 million lawsuit was settled out of court in February last year, but the affair “caused some reservation among management boards and didn’t make it any easier for subsequent deals”, says Potthof.

Once bitten, HSH is now twice shy. The bank still invests in CDOs, buying roughly €100m slices of four to five deals each year, says Martin Halblaub, head of global markets for HSH. Like the most sophisticated investors, the bank is comfortable approaching arrangers with precise specifications for bespoke tranches – but it devotes huge resources to vetting the deals.

“You have to be careful with bespoke transactions. Are they being driven by the investor’s specific requirements, or is the arranger building a structure which allows it to offload risks it doesn’t want?” asks Halblaub.

That’s a message that investors have taken to heart – and they are getting increasingly savvy, says DWS’s Römer. “Investors look intensively at how the concept works, at the company behind it, and at how it has performed in the past. The demand is higher than ever before but investors are also choosier than they’ve ever been as well.”

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