Losing some of their shine
Schuldscheindarlehen (SSDs or Borrowers’ Note Loans) are financial products which are familiar to the German market. They have a long tradition in Germany, in particular as a funding instrument for industrial corporations as well as an investment instrument for institutional investors. Nevertheless, factors like the securitisation of debt, the globalisation of the investor base and declining deficits of the public sector have led to a declining utilisation of SSDs. As a consequence, several investors have begun to question the future role of the SSD.
SSDs are not bonds in the legal sense and thus are not security issues. They represent loans, documented by a negotiable promissory note called a Schuldschein (SSN). The SSD usually includes the creditor’s and the borrower’s name, the nominal amount, the interest rate, the payment dates, the maturity date, the number of possible transfers and further specific arrangements. The legal framework for a SSD is contained in the German Civil Code (§§ 607-10).
A SSN can be transferred to third parties by way of a “written assignment”. The contracting parties have to advise the debtor about the transfer of the SSN. The possibility of a transfer via assignment is a unique feature of the SSN, setting it apart from the normal bank credit. Since SSNs are frequently traded in the German market, they are quite similar to other fixed income instruments and are viewed as part of the bond market.
The minimum denomination of a SSN is generally e10m and can be as large as e250m. The ordinary volume size is e25m. Although there are no restrictions on their maturity, a range of between two and 10 years can usually be found. The loan agreement between the borrower and the investor usually stipulates that the claim in respect to the note can be assigned to other investors fully or partially. With respect to the issuer, a SSN has several advantages compared to a bond. A SSN can be issued at any time on short notice without having to comply with the technical procedures involved in security issuance (ie, selection of the managing banks, holding of road shows, introduction to a stock exchange). As a SSN is usually launched via private placements, it normally takes only a matter of a few minutes for issuance.
There are no additional costs associated with issuance (road shows, listings with stock exchanges, etc). Hence, SSNs generally offer the opportunity for the borrower to fund at lower levels, while the yield can be higher for creditors than with security issues.
The terms of a SSD, which are agreed to on an individual basis, can be tailored very flexibly to the requirements of the contracting parties. Several variations have been developed, in particular regarding the type of interest rate, the actual fixing of the interest rate which applies, the currency, the settlement date as well as the possibility of the loans being callable. According to the German Civil Code every SSD (except for public sector SSD) can be called after 10 years, even if the loan contract explicitly excludes such an action! Furthermore, various types of financial engineering can be combined with SSDs.
There is more discretion compared to a bond issue. The issuer has the opportunity to fund relatively large amounts without details of the issuance becoming public knowledge.
SSDs used to represent the most important source of financing for the public sector. However, the importance of SSD has declined, with their share of total outstanding public debt falling to about 35% in September 2000 from around 75% in 1981, corresponding to an amount of e436.7bn. At the same time, the importance of securities has increased to almost 60% (e709.7bn) from about 20% in 1981 (see Figure 1).
Generally, three main factors can be cited to explain this development. First, the abolition of the coupon tax in 1984 (from which SSNs were exempted) encouraged the federal government to resort more and more to raising funds via genuine bonds. Secondly, German reunification created a huge capital requirement of the public sector, which was mainly satisfied by the issuance of bonds. Finally, since 1997 the federal government has stopped issuing any medium- or long-term SSNs. The federal government started to concentrate its funding activities on the bond market in an effort to achieve benchmark status for its bonds .
As a consequence, the federal government has cut its borrowings via SSDs from about DM173bn in 1983 to around DM25bn in 1998. Currently outstanding SSD issued by the federal government amount to about E58bn (September 2000). The increase in the outstanding amount of SSD in 1999 was caused by the joint responsibility of the federal government for several special funds (like the Redemption Fund for Inherited Liabilities) since July 1, 1999. These special funds financed a large amount of their outstanding debt via SSDs. The federal government itself has only issued short-term SSN-secured loans (maturity below one year) to support its cash management since 1997.
Although the importance of SSDs as a financing vehicle for the federal government has declined, they are still the most important financing instrument for the Laender (state) governments and local authorities. At the end of September 2000, the total outstanding volume of SSDs of the public sector amounted to e854.2bn, of which about 61% were issued by state governments and 22% by local authorities. The share of SSD as a funding instrument for the state governments as well as for local authorities has declined only slightly (Figure 3).
SSDs are also an important refinancing instrument for agencies (like the KfW) and for the private sector (like banks, special credit institutions or industrial corporations). Nevertheless, as there is no official registration of the issuance of a SSN, no reliable record about the outstanding volume of private SSD is available.
Typical buyers of SSNs are domestic institutional investors who generally wish to invest large sums until final maturity. For these investors SSNs are attractive because they are not obliged to make any write-downs in case of price losses. According to the German Commercial Code, loan claims can always be reported with the nominal amount on the balance sheet. On the other hand, the low liquidity of SSNs is clearly a disadvantage. SSNs are not traded on a stock exchange and their method of transfer is antiquated. Additionally, in particular public sector SSNs are transferable only three times. Although these SSNs could be transferred for an additional time with the explicit permission of the issuer, the attractiveness of SSNs is dramatically impaired. However, since 2001 the newly emitted SSNs of public sector borrowers can be transferred without any limits.
Regarding public sector SSNs, German mortgage banks and Landesbanks (banks affiliated with the various states) are clearly the most important investors. At least 85% of the total outstanding amount of public sector SSNs are held by these investors to offset their issued bank bonds on their balance sheets. Domestic insurance companies are also large purchasers of SSNs. With respect to the latter, the regulations of the Law on the Supervision of Insurance Undertakings are relevent. As a consequence, domestic insurance companies usually buy only SSNs of issuers who comply with the requirements of the premium reserve stock. At the end of 1999, the total amount of SSNs held by domestic insurance companies was around DM245.6bn, while credit institutions were by far the biggest debtors (Figure 4).
In the secondary market SSNs are either traded on a yield basis or priced vs. the swap or the DGZF curve. They are traded in lots of round millions with the normal transaction frequently being a double-digit million euro amount. The liquidity of SSNs is very low. No active trading in SSNs occurs as short positions cannot be covered.
Generally, the pricing of a SSN is determined by two factors. First, the price is usually linked to the pricing of the liquid bonds of the respective issuer or of a similar issuer. Due to their limited liquidity SSNs usually trade at a slight yield pick-up vs similar bonds. Secondly, as the number of possible transfers declines, the need for the SSN to be placed with a final investor increases, which means that a premium will be demanded. With respect to the SSNs of German Laender, the yield pick-up per lost transferability amounts to about 2 to 3 bp.
Given that German mortgage banks and Landesbanks are the main purchasers of public-sector SSNs, the future of this financial product is clearly linked to the public financing activities of these banks. An assessment of the future demand of mortgage banks for public sector SSNs depends on their need to gap the curve and to incur interest rate exposure in order to compensate for negative margins when running a maturity-matched funding. Since 1999, public sector borrowing by German mortgage banks and Landesbanks was limited due to the dramatic flattening of the yield curve and the low Jumbo swap spread volatility. These factors will drive the demand for public sector SSNs in the future as well.
Furthermore, due to a rise in yields accompanied by a flattening of the yield curve in 1999/2000, the Federal Banking Supervisory Office started to take a closer look at the interest rate exposure of German mortgage banks. As a consequence, mortgage banks will have to disclose their interest rate exposure in more detail than in the past. Overall, this will cause mortgage banks to act far more conservatively in the public loan business in the future. Relative to the issuance of bonds, the advantages of funding via SSD have declined. Consequently, state governments have recently started to execute more of their funding via bonds. Nevertheless, SSDs will still be used as a central instrument for the funding of state governments and local authorities. One must remember that SSDs, combined with derivatives, are used by public authorities to optimise their debt structure and to reduce their funding costs.
Additionally, the federal government transferred the managing of the public debt to a new Financing Agency. There are reasons to assume that at least a substantial part of the funding of the Laender governments (and probably of the local authorities as well) will be done by the agency
in the future. As the federal government is not expected to resuscitate medium- and long-term SSD
as a funding instrument, this development will eventually lead to a reduction in the issuance of public sector SSD.
Jens Müller is a fixed income strategist with HypoVereinsbank in Munich