Using N bonds to access the German market

Author: | Published: 1 Jul 2012
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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.

 

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