How a Quirky German Credit Instrument Is Going Global

(Bloomberg) -- When a beloved local product ramps up production, there’s always a question of whether it can gain new fans without losing what made it special. Something similar is happening with a German debt instrument known as Schuldschein, a hitherto hidden corner of the market where new volume records have been set every year since 2017. Companies from across Europe, and even the U.S. and Asia, are turning to Schuldschein as a way of borrowing sums from investors as far afield as China. The instruments are also starting to be used for “green” investments. But some of this new-style lending has blown up. How well can artisanal financing fare on the global stage?

1. What is a Schuldschein?

Schuldschein (pronounced schult-shine) is an alternative way to raise funds. Not quite a loan and not quite a bond, traditional Schuldschein promissory notes were created by German lenders for reputable local borrowers such as Volkswagen AG and publisher Axel Springer SE. Deals can run from 10 million euros ($11 million) to more than 1 billion euros, and they can include tranches of different maturities and currencies. Raising a Schuldschein is similar to obtaining a loan: A company asks one or more banks to arrange a deal, which is then syndicated before final pricing is set. Each tranche is then divided up into various-sized slices and issued to lenders, who sometimes number in the hundreds.

2. How is a Schuldschein like a bond?

Deals can have maturities surpassing five years, which is more like a bond than a loan. The notes also offer greater access to institutional capital-markets investors, such as insurers and pension funds, than the bank-dominated loan market. Investors have the option of selecting fixed-rate pricing on tranche slices, whereas corporate loans are almost always floating rate. Schuldschein lenders generally pick fixed rates for long-dated tranches and floating rates for shorter tranches.

3. Who uses them?

Smaller companies with sales of less than 5 billion euros dominate the Schuldschein market by the numbers, according to a European Commission report. This reflects the fact that German banks often use the notes to make loans to the Mittelstand, the nation’s network of small manufacturers. Local lenders likewise dominate the arrangers league table, with Landesbank Baden-Wuerttemberg, or LBBW, Landesbank Hessen-Thueringen Girozentrale, or Helaba, and Bayerische Landesbank at the top of the ranks. Now the market is expanding beyond its traditional heartland of Germany, Austria and Switzerland. Asian lenders have targeted Schuldschein as a growth opportunity, and the Bank of China Ltd. and Japan-based Mizuho Financial Group Inc. have already helped manage deals. Volume from other countries tripled in the first half of 2019 to make up 43% of new deals.

4. What are the advantages for borrowers?

Schuldschein are favored in Germany because they’re private, simple to use and based on local law. The market is light on paperwork, with even 1 billion-euro deals only having agreements comprising a few pages at most -- a marked difference to doorstop-sized bond prospectuses. There’s no requirement to publish deal terms because Schuldschein aren’t publicly traded or covered by transparency rules under the European Union’s MiFID II regime. Further cost savings come from not needing a credit rating.

5. What’s in it for lenders?

The biggest lure is comparatively high yields from generally investment-grade borrowers. Lenders can also expect Schuldschein borrowers to draw down the financing, which is better than being paid low fees for providing untapped revolving credit facilities. Also, unlike bonds, Schuldschein don’t have to be marked to market. That’s a boon for investors as the pricing of the instruments doesn’t fluctuate like bonds.

6. What are drawbacks of Schuldschein?

Even with recent growth, only 26 billion euros of Schuldschein were sold last year, about a 10th of the amount raised in Europe’s investment-grade corporate bond market. Renegotiating terms in the event of a cash crunch is cumbersome because deals need to be struck with every lender individually. For lenders, Schuldschein investing can entail more legwork than bonds due to the lack of financial transparency and credit reports. The market is also less liquid than bonds, partly due to a predominance of buy and hold investors. Out-dated systems and processes also deter trading and boost administrative costs.

7. How is the market changing?

The Schuldschein market is becoming digitized, with at least seven different online platforms competing to automate deal management, potentially replacing a mess of manually updated spreadsheets, phone calls, emails and faxes. VC Trade is the largest, with more than 300 investors and deals with arrangers including BayernLB and Helaba. LBBW is backing a rival system called Debtvision. The Schuldschein market has also followed wider growth in socially responsible investing. Sports-car marker Porsche AG issued a record 1 billion-euro green Schuldschein in August, while Duerr AG became the first borrower to sell a deal with pricing linked to sustainability performance.

8. What about those blowups?

The downside of growth is that risk has increased in a market that traditionally saw few defaults. Investors in a 131-million euro Schuldschein were wiped out in early 2018 amid the collapse of U.K. contractor Carillion Plc. More than 100 investors in a 755-million euro facility were also caught up in South African retailer Steinhoff International Holdings NV’s financial troubles. This shows that increased risk is likely to be a consequence of growth in the once rock-solid Schuldschein sector, as it continues to expand beyond the realm of just highly-rated German companies.

The Reference Shelf

• Bloomberg Markets explains how Schuldschein arrangers are turning to digitization to boost issuance and cut costs.
• The Loan Market Association’s guide to Schuldschein.
• Bloomberg News survey shows Schuldschein investors’ caution about globalization.
• Bloomberg News reports on how Folli Follie restructuring highlights risks as economy falters.
• A guide to finding Schuldschein information on the Bloomberg terminal.

To contact the reporter on this story: Jacqueline Poh in London at jpoh39@bloomberg.net

To contact the editor responsible for this story: Hannah Benjamin at hbenjamin1@bloomberg.net

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