Germany has traditionally had a huge savings surplus. Its aggregate
savings exceed its domestic investment. It therefore is a net exporter
of capital. Most of this capital is pooled by institutional investors
and a substantial part of it is invested in securities issued abroad. In
the past, these securities were often financial innovations (such as
asset-backed securities and collateralised debt obligations) that had
been developed in New York and London. Investors were driven by the need
to combine a safety comparable to government bonds with the yield they
required because of the returns promised to their own investors.
Decisions were often taken primarily on the basis of ratings. The
securities were mostly governed by New York and English law and the
structures relied on special purpose vehicles, limited recourse and
different tranches of risk.
The financial crisis has accelerated another trend. Foreign issuers
increasingly use German techniques and concepts. These are often new in
the jurisdiction of the issuer (especially in the common law
jurisdictions). But they have a long tradition in Germany (as well as in
some other jurisdictions such as Denmark) where they have existed for
several hundred years and have become a symbol of safety and
reliability: Pfandbriefe, or covered bonds, and specifically
covered bonds in the form of a peculiar German debt instrument
(essentially a hybrid between a bond and a loan) the German Namensschuldverschreibung.
The prestige of the Pfandbrief in Germany can hardly be
overestimated. It was emphasised again at the height of the financial
crisis when the federal government said in the official reasoning of the
stabilisation legislation that Pfandbriefe are "safe already", that in its "more than 200-year history" there has never been a default on a Pfandbrief
and that "the federal government will ensure that this remains the case
also in the future". This was not a formal guarantee (which would have
been harmful for the Pfandbrief because it would have turned it
into a government bond) but it was a far-reaching political commitment
that was referred to in the industry as the Vertrauenserklärung – the declaration of trust.
It is against this background that a debt instrument that used to be
seen as a less than glamorous predecessor of structured finance became a
model for other jurisdictions. Issuers from many jurisdictions were
attracted and made an effort to issue instruments which were as close as
possible to the German original. Often new covered bond legislation was
introduced to ring-fence the cover pool in the event of an insolvency
of the issuer. Other jurisdictions relied on structural or contractual
solutions, namely cover pools held by a separate entity which then
issued a guarantee. This resulted in a functional equivalent to the Pfandbrief
since it created the same combination of an unlimited recourse to the
issuer and privileged access to the cover pool. Moreover, specialised
regulatory supervision was introduced in order to satisfy the criteria
applicable to fund investors and German institutional investors.
N-what?
One of the new concepts foreign issuers encountered was the Namensschuldverschreibung
– a word that most non-German-speakers find impossible to pronounce.
This key obstacle to its international success was removed when (in the
context of the documentation for a Canadian issuer) the idea was born to
call the instrument an N bond or N covered bond.
N bonds are very peculiar German debt instruments. They are not
bearer bonds but are very different from English or New York
law-governed registered bonds as well. The old practice of calling them
German law registered bonds is therefore misleading. It is true that N
bonds typically involve registers of bondholders. These are kept either
by the issuer or by a registrar on behalf of the issuer. This is,
however, merely a question of market practice. In order to issue an N
bond, a register is not required. What is required is a physical
certificate issued in the name of the investor. An N bond thus is a debt
instrument which evidences an obligation of the issuer and is made out
in the name of the creditor. Hence the German term Namensschuldschreibung
which means "name bond". The obligation of the issuer is not
transferred by delivery of the certificate: it is assigned in the same
way as a loan. For this purpose the N bond will usually be accompanied
by a form of assignment agreement in the same way as a syndicated loan. N
bonds may be assigned fully or partially which means that they are
split up into several N bonds (each evidenced by a new certificate). The
terms and conditions of N bonds will also typically provide that the
transfer requires registration of the new bondholder(s) in the register
which is kept by the issuer or a registrar. Upon assignment, title to
the certificate passes to the new creditor by operation of law. Each new
creditor is then entitled to a new certificate being issued in its
name.
N bonds are not securities in the narrow sense (in the sense that the
right evidenced by the instrument passes when title to the instrument
is transferred). N bonds are securities only in a wider sense, namely in
the sense that, at least in principle, the certificate is needed to
enforce the rights of the bondholder. For a number of important purposes
(including most importantly accounting purposes) N bonds are treated
like loans.
Given their similarity to loans, N bonds may not be cleared in a
clearing system. Since clearing is usually a requirement for listing
they may not be listed either. N bonds are not actively traded. Most
investors are buy and hold investors: they intend to hold the N bonds
until maturity. The transfers which do occur are mostly those from the
bank involved in the placement of the N bond to the initial purchaser or
from an initial purchaser to its subsidiaries (for example within a
group of insurance companies where the investment is then allocated to
subsidiaries). N bonds are not deposited with securities depositories.
They are kept in physical form by the investor. There are no global N
bonds. They are definitive physical securities made out in the name of
each investor.
At first sight, the absence of an active secondary market may appear
to be a disadvantage. However, it is precisely this which attracts
investors because it justifies what investors find most attractive about
N bonds, namely their accounting treatment. N bonds do not have to be
marked-to-market. From an accounting perspective, they are treated like
loans and can be shown in the balance sheet at amortised costs.
Fluctuations in the market value result in hidden gains or losses, thus
reducing volatility. It is hardly surprising, therefore, that the
financial crisis has given a further boost to N bonds. According to Bundesbank statistics, the majority of all outstanding Pfandbriefe
are now in N bond form and a large number of foreign issuers have
started to include N bonds in their covered bond programmes or have
started to issue them on a standalone basis.
N bonds and Schuldscheine
N bonds should not be confused with another similarly illiquid German
debt instrument, the German certificate of indebtedness, or Schuldschein, which benefits from the same accounting treatment. Also hybrids between bonds and loans, Schuldscheine are even closer to loans. Unlike N bonds which constitute bonds (Schuldverschreibungen) for purposes of the German Civil Code, Schuldscheine
are loans also for purposes of the Code and are therefore subject to a
mandatory termination right of the borrower after 10 years if the rate
of interest is fixed. As regards unsecured debt it is therefore common
to issue a Schuldschein for maturities below 10 years and N bonds for longer maturities. Pfandbriefe
or covered bonds under the covered bond regime of other jurisdictions
may only be issued in N bond form (irrespective of the maturity) since a
Schuldschein will not meet the first and most basic requirement of any covered bond, namely that it be a bond.
Regulatory features
Although a bond for purposes of the Pfandbrief Act and foreign
covered bond legislation, N bonds are not securities for purposes of
the Prospectus Directive. They therefore do no require a prospectus
under the German implementation of the Prospectus Directive or that of
another member state of the European Union. There is national German
legislation imposing a prospectus requirement, among other things, on a
public offer of N bonds. However, N bonds are merely offered to
professional investors and are usually privately placed so that one or
more exemptions from the prospectus requirement are normally available.
Unlike bearer bonds, N bonds are not generally exempted from the
definition of deposit taking (the raising of repayable moneys from the
public). A public offer of N bonds in Germany (especially to retail
investors) would thus require a German banking licence covering deposit
taking or an equivalent licence from another member state of the
European Union which could be used as a European Passport. Retail
investors do not buy N bonds, however. The key advantage of N bonds,
namely their accounting treatment, is not relevant for retail investors.
The typical institutional investors who buy N bonds are not regarded by
the German financial services authority (the BaFin) as belonging to the
general public for these purposes.
The investors (predominantly German insurance companies and pension
funds) buy N bonds almost exclusively as part of their restricted assets
(assets especially ring-fenced for the benefit of policy holders in the
event of an insolvency of the insurance company or pension fund). This
means that N bonds need to include a waiver by the issuer of set-off
against any counter-claims (to avoid a commingling of assets). Moreover,
investors must comply with the Investment Regulations for the
Restricted Assets of German Insurance Companies. Investors will
typically want to ensure that the N covered bonds satisfy the criteria
of covered bonds under these regulations. This means that the issuer has
to be a credit institution, that the proceeds are invested in assets
ring-fenced for the benefit of the bondholders and that the assets are
sufficient to cover the liabilities under the covered bonds during their
entire maturity. Moreover, specialised covered bond regulation and
regulatory supervision is required. This does not mean that the
ring-fencing of the assets has to be based on statutory provisions (such
as special insolvency laws). A ring-fencing based on structural
solutions (especially cover pools held by separate entities which
provide a guarantee) is sufficient if it is accompanied by specialised
regulatory provisions.
Governing law
Although there is no provision in the Pfandbrief Act requiring this, Pfandbriefe
(be it in N bond or bearer form) are only issued under German law. When
foreign covered bond issuers started to issue their covered bonds also
in N bond form the question arose whether N bonds could be governed by
the laws of the issuer's jurisdiction. However, the practice has become
to issue N bonds exclusively under German law. N bonds are very peculiar
German law instruments for which there is usually no equivalent in
other jurisdictions. Moreover, German law N bonds are seen as more
attractive by German institutional investors.
Combining a German law governed N bond with a covered bond regime
under foreign law presents a number of special challenges. In order to
be attractive for German investors the N bond has to be as similar as
possible to a Pfandbrief in N bond form while issuers, rating
agencies and local regulators will want to ensure that it is, as far as
possible, a functional equivalent of the covered bonds issued under
local law. Given the very different legal characteristics and practical
mechanics of N bonds, these two objectives cannot easily be reconciled,
especially in the jurisdictions where the covered bonds rely on
structural and contractual arrangements. Covered bonds in such
jurisdictions typically include bond trustees and bondholder meetings
which are convened across different series of covered bonds. Neither of
these features are found in German Pfandbriefe. Additional
contractual arrangements may be necessary in order to ensure that the
position of N bondholders is the same as that of the holders of covered
bonds under the local law of the issuer. The N bonds may or may not be
described in prospectuses that are produced with respect to the covered
bonds in bearer form. They may also be issued purely on a standalone
basis. It may be advisable to produce additional German language
documentation and sales material in order to ensure a successful
placement. Since N bonds are privately placed with institutional
investors, the issuance process will typically involve a much more
active dialogue between investors, arrangers and issuers than is
typically the case where bearer bonds are issued through the clearing
systems. This is a new experience for many issuers, but is part of an
effort which allows them to diversify their funding sources or allow,
placements of covered bonds which otherwise may not be possible or not
at such favourable terms. A large number of (especially German)
institutional investors make the majority of their fixed income
investments in N bond form and will not consider covered bonds in any
other form. Many foreign issuers (including many UK issuers) have
already taken advantage of this and it is likely that the trend towards N
covered bonds will continue.