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German cities line up for bigger slice of capital markets action

[LONDON] German cities are expected to ramp up their capital market activities as they feel the squeeze from increased funding needs and regulatory changes.

While still a very small market, with only three public transactions sold in 2014 and less than 2bn raised since 2009, market participants believe it will grow in the coming years.

"The introduction of the leverage ratio provides an incentive (for banks) to shift away from high volume and low margin business towards low volume and higher margin business," said Fritz Engelhard, managing director, fixed income strategy at Barclays.

"It reduces the incentive to provide funding to local authorities, who were used to paying tight margins in the past. Some of the larger cities may thus try and develop capital markets funding as an alternative."

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Unlike the Common Equity Tier 1 ratio, which captures the riskiness of loans, the leverage ratio is simply a bank's capital relative to a gross measure of its exposures that has been unadjusted for riskiness.

Mr Engelhard pointed out that many German public sector banks funded local authorities from the issuance of state-guaranteed debt until 2005, allowing them to offer cheap financing.

"Most of this debt expires in 2015 and thus the volume of available funding simply decreases. This is eventually intensified by the fact that some of the Landesbanks have been subject to substantial restructuring over recent years, focusing more on profitability again than on balance sheet growth."

This comes at a time when funding needs are growing. According to Commerzbank analysts, the latest KfW Municipal Panel puts the pent-up investment needs at around 120bn.

They add that municipal demand for short term liquidity loans (Kassenkredite) has grown markedly. "Since reunification, the volume of liquidity loans has increased from a mere 1.5 billion to almost 50 billion this year, having reached a share of 35 per cent of total municipal debt," they wrote.

As one senior German syndicate manager said: "Ideally, and only ideally of course, cities would not be indebted at all, and only bridge-finance temporary - if any - shortfalls by what you may call 'tolerated overdrafts' or Kassenkredite. It goes without saying that this overdraft financing has reached enormous levels which creates some need to reconsider cities'refinancing."

German cities have a range of options at their disposal to tackle these financing needs. Some of the bigger cities like Berlin and Hamburg have been funding in bond markets for many years.

Even those with smaller requirements have found a way of teaming together, like Nuremberg and Wuerzburg that sold a 100m 10-year deal in May 2013, or NRW Cities that raised 500m of February 2018 bonds or "Staedteanleihe".

A steady stream of commonly issued municipality bonds ("Gemeinsame Kommunalanleihen") is also expected.

Cities instead can go it alone like Ludwigshafen, which sold a 150m 10-year in November 2014.

Others have hit the Schuldscheine market. Hesse and NRW allow their cities to issue out to 10-years in that format, while Lower Saxony allows out to four years. Several cities have taken advantage of some recently relaxed rules on city funding that broaden the range of tools they can use.

Market participants believe the nature of the bonds means that there should be plenty of demand.

"Given the guarantee structure, such bonds' risk weight is 0 per cent, in line with other German Laender debt," Citigroup analysts said in a note published at the end of October. "In our understanding, this would make such bonds also eligible as Level 1 assets for the liquidity buffer of European banks (LCR). Moreover, the higher issuance volume should be supportive for secondary market liquidity."

They believe that over-indebted municipalities would eventually be supported by the federal state. "While eventually being German risk, such bonds offer a spread pick-up of up to 60bp over Bunds," they wrote.

Given the ECB is buying pfandbrief and pushing spreads ever tighter, any new cities should find solid demand with a positive spreads to swaps likely to appeal to insurance companies and banks.