German cities, struggling to raise capital from traditional lenders, are turning instead to the capital markets for succour. The growth in the market for municipal debt is slow but sure, with many cities ganging together to issue debt in larger tranches, in the hopes of tapping more regional and global investors. So far, the plan is working, but what will the future hold?
We all clamour for the new and exciting, the fresh and untested, even when it comes to the international debt markets. Take bonds issued by unrated German cities, an asset class offering debt packaged by reliable, stolid Burgermeisters and seasoned with just a smidgeon of added yield. The market remains small, to be sure, with just three transactions sold in 2014 and less than €2bn (US$3bn) raised since 2009, according to data from Thomson Reuters, yet it is set to prosper in the years to come.
Demand for German municipal debt is growing. And while it may look, smell and taste new, in reality it’s an offshoot of a successful existing investment instrument: debt issued at the sub-sovereign level by the 16 Laender or states that form the Federal Republic of Germany. That asset class is a genuine monster, entailing the financing and refinancing of around €90bn worth of annual debt, blending benchmark bonds and Schuldscheine – traditional floating or fixed-rate instruments with a typical maturity of between two and 10 years.
Only in the past two years have German cities started to eye up the possibility of issuing their own paper. They started slowly, opting for a safety-in-numbers approach. A key deal came in February 2014, when six northwest German cities including Dortmund, Essen and Wuppertal, joined forces to launch NRW Staedteanleihe No 1, a four-year deal led by HSBC, Helaba and Deutsche Bank. It started slowly but gathered speed, raising €400m at mid-swaps plus 35bp. The six cities returned to the market late last year to tap investors for a further €100m.
Encouraged, other cities started to eye up the possibility of issuing their own debt. In November 2014, the central German city of Ludwigshafen went solo, printing €150m worth of 10-year paper that started as a €100m deal at mid-swaps plus high-40s before being priced at mid-swaps plus 41bp. Others, such as the Rhineland-Palatinate city of Mainz, have also chosen to go it alone.
Bankers are hopeful that this is just the start. “It’s a small market – way smaller than the market for Laender debt, but it’s also fascinating,” said Carsten Lohle, director of capital market and treasury solutions at Deutsche Bank. “Many cities are now evaluating their options here. The market offers lots of flexibility – the cities can take advantage in the form of Schuldscheindarlehen and/or single or multi-issuer bonds.”
This is an asset class in dire need of working capital. Many admire Germany’s economy and its equable federal structure, set up by the Allies after World War Two, but many of its major cities teeter on the edge of bankruptcy. High social costs hardly help, but of equal concern has been the failure of a coterie of once super-reliable public-sector lenders. Regional lenders such as WestLB, Landesbank Berlin and HSH/Nordbank, were shuttered, forcibly merged or nationalised after the financial crisis. The ongoing struggles of Irish-German public-sector lender DEPFA Bank, now overseen by a bad bank in Munich, ripped away another reliable source of financing for German city chiefs.
Desperate for fresh funding, they turned warily to the capital markets. At first, there was good reason to be circumspect, for both issuer and investor. Unlike the states that surround and envelop them, all of which are rated Triple A by Fitch, German cities remain unrated, forcing investors to do their own credit research before buying municipal bonds. They are also far less financially transparent, an issue that will need addressing if the asset class continues to expand.
Yet all parties have solid reasons to encourage cities to tap capital markets more vigorously. For issuers, there is a glaring need to fill budgetary holes, plough new funding channels, and secure a solid credit rating. Commerzbank puts the pent-up demand for investment among Germany’s 12,500 towns and cities at around €120bn.
Eurozone lenders meanwhile may be forced to raise upwards of €30bn this year and next to meet more demanding leverage ratio requirements. That could induce them to move towards a lower-volume, higher-margin effort, embodied by the opportunity to package and sell higher-yielding municipal debt.
Investors in turn will be tempted by the yield. So long as they remain unrated (though that should change as the asset class grows), issuers are forced to pay up, at least compared with larger and better-established Laender. The NRW Staedteanleihe No1 was priced with a 1.125% coupon, putting its premium against rated Laender paper at around 38bp in swap terms, or 25bp against Bunds.
“I see the lending market for German municipality debt remaining reasonably lively, with investors continuing to look for any pick-up in yield that an issuer can offer,” said Pierre Blandin, head of SSA debt capital markets at Credit Agricole.
Said Deutsche Bank’s Lohle: “With cities offering a fair pick-up in yield versus regional or state debt, this should become an increasingly viable investment opportunity for the likes of bank treasuries.”
The European Central Bank’s €1.1trn quantitative easing plan, launched on January 22, should act as an extra fillip for issuers in a market short on high-quality assets offering an extra slice of yield.
“I see the lending market for German municipality debt remaining reasonably lively, with investors continuing to look for any pick-up in yield that an issuer can offer”
A few added bonus points stand out. First, the average print size is growing as cities gang together to raise more capital in a single outing, pushing average issuance toward the €500m mark. Bankers tip the multi-issuance model to become a regular feature of the sector as it expands. Last year’s NRW Staedteanleihe No1 sale “was a clear point of evolution for municipal debt”, said Deutsche Bank’s Lohle.
“It moved the market up a gear, and in terms of publicity alone, it garnered the attention of many new accounts. Not all took part, but for the first time they were convinced enough to do credit work on city debt.”
Non-domestic interest in city debt is also growing. Bankers point to rising interest from institutions outside the country’s borders, with investors from Austria and Luxembourg placing 7% of orders for the NRW Staedteanleihe No 1.
Risk – or the lack of it – should be the final motivating factor for investors. German cities, even stretched industrial or commercial centres such as Essen or Duesseldorf, cannot, under national law, enter bankruptcy. Federal law implicitly guarantees all debt incurred by any municipality within a state’s borders, thus virtually eliminating any repayment risk. That guarantee structure, analysts at Citigroup said in an October 2014 research note, cuts municipal bonds’ risk weight to 0%, in line with Laender debt.
The range of financing options available to city leaders is only likely to improve. Some German cities – Berlin and Hamburg spring to mind – have been tapping debt market investors for years. Others are still dipping their toes in the water or eyeing the sector from afar, pondering the benefits of going solo on deals, or joining forces with others. Yet others may opt to saddle up with a like-minded peer, following in the tracks of Nuremberg and Wuerzburg, which teamed up to issue a €100m, 10-year print in May 2013.
“Many cities are now evaluating their options here. The market offers lots of flexibility – the cities can take advantage in the form of Schuldscheindarlehen and/or single or multi-issuer bonds”
Either way, investors point to a steady stream of jointly issued “Gemeinsame Kommunalanleihen”, or municipality bonds, in the years to come. Regional authorities are even tinkering with their own rules to boost city-level capital markets funding. Two of Germany’s more industrial western states, Hesse and Nordrhein-Westfalen, have relaxed their rules to permit cities to issue 10-year debt, with Lower Saxony raising the bar to four years.
Bankers interviewed for this article point to a raft of deals they are currently working on, mostly multi-city deals aiming to raise north of €500m in the months ahead. “We have to see how those discussions proceed,” said one DCM banker. “So far, though, things are looking good. This could be a very big year for city debt.”
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