The rise of asset-backed bonds
The latest regulatory developments could further increase the appeal of asset-backed bonds for real assets, says Thomas Morgenstern
Providers of closed-ended investment funds in Germany focus increasingly on institutional investors. Since the limited partnership model under German law is less than attractive for many institutional players, German fund providers turn increasingly to bonds. The trend is boosted by the transposition of the Alternative Investment Fund Managers Directive (AIFMD) into German law.
Institutional investors have recently intensified their quest for alternatives to classic investment segments such as equities or government bonds. For insurance companies, pension funds and other institutional investors, the current situation on the capital market is anything but perfect. The global stock markets are experiencing extraordinary fluctuations at the moment, and therefore have limited appeal to this safety-driven group of investors.
The equity weighting of most institutional investors is currently well below 10%. Yet government bonds, especially those from the euro-zone, imply virtually incalculable risks. At the same time, the interest paid by high-credit countries is extremely low – in some cases actually being negative. To put it bluntly, government bonds are offering yield-free risk rather than risk-free yield. The situation presents a particular challenge to institutions because their commitments in government bonds are traditionally high.
One alternative for institutional investors is corporate bonds, which have moved centre stage for this type of investor because some of them present highly attractive risk-return profiles. The LBBW state bank determined that European companies have issued approximately €130bn worth of bonds since the beginning of the year. LBBW expects euro bond placements to reach a volume of €180bn before the end of the year. For the sake of comparison, the total for 2011 was approximately €135bn.
Another alternative for institutions is tangibles such as real estate, infrastructure and energy investments, which in Germany is the domain of closed-ended fund providers. Indeed, the latest planning figures show that the share of institutional investors is on the rise. After €620m placed in 2010, German providers of closed-ended equity investments raised more than €1bn from institutional investors last year, according to VGF, the Association of Non-Tradable Closed-End Funds. This is nearly a fifth of the entire volume of placed equity. During the second quarter of 2012, the share of institutional investors actually rose to 30%.
Despite the recent growth, the institutional investor business of closed-ended fund providers has remained modest so far. This can be explained by the limited partnership model under German law – for many insurance companies and pension funds, limited partnership interests are less attractive than special fund or bond investments. The main reason is that partnership interests tend to be included in the proportionate equity interest and therefore need to be backed with more equity than is required for bonds, for instance. It comes as no surprise therefore that numerous institutions have lately stepped up their efforts to find a bond construction that would ensure stable recovery of capital.
Another reason is that institutional investors have advanced requirements in terms of fungibility and the continuous revaluation of their investments. In this context, bonds – especially listed ones – have a clear advantage over limited partnership interests. While partnership interests are virtually impossible to sell, except through secondary market platforms, most bonds are listed at the stock exchange. Another advantage is that bonds are deposited at a custodian bank, which ensures periodic valuation.
The trend toward bond models could be further boosted in the future by the contemplated ban on open-ended special real estate funds, an idea that is currently discussed within the framework of implementing the AIFMD. To what extent insurance companies, pension funds and superannuation schemes will opt for foreign fund vehicles instead, or deepen their focus on bonds even further, remains to be seen.
An option for fund investment companies that intend to offer tangible investments is asset-backed bonds. These are issued not by the initiator but by a company specifically set up for the purpose. Unlike conventional corporate bonds, these are issued not by the initiator but by a company specifically set up for the purpose. The capital raised is then used to finance an investment in tangible assets. These vehicles often include other stakeholders, too, such as lenders and equity providers. Investors subscribing these bonds will be paid fixed interest payments instead of distributions. Of major advantage for investors is the following difference: the interest collected during the life cycle will not have to be paid back if the investment becomes distressed later on – unlike the distributions of German closed-ended funds.
The possibilities to invest in tangibles through bonds are nowhere near exhausted. The increased focus on institutional investors will expedite this development. Moreover, the implementation of AIFMD into German law will cause the attractiveness of bonds to surge dramatically. After all, closed-ended funds will be subject to much stricter regulation in Germany than before.
Major passages of the draft proposal writing AIFMD into German law have sent shock waves through the industry. The scope of the regulations far exceeds the terms anticipated by most market players. Even if the parliamentary process was to bring about some changes in the draft bill, the regulatory requirements in closed-ended funds will clearly exceed the present standard. Many initiators will have a hard time to launch new funds under these parameters. In order to dodge the regulations that the draft proposal envisions for future limited partnership models, numerous providers will therefore opt for the alternative of bond structures.
That said, bonds represent regulated vehicles in their own right. Bond issuers are subject to extensive regulatory requirements and transparency obligations – one being that they need to compile and publish an extensive issuing prospectus. On top of that, bonds are subject to very high transparency standards. Obtaining a rating, for example, is almost mandatory for an initial public offering. The regulations governing this segment cover not just the vehicles and the issuers, but the rating agencies themselves. The latter are obliged to have their valuation methods approved by the European Supervisory Agency for Financial Services, and are continuously monitored by the European System for Financial Supervision.
Thomas Morgenstern is CIO at Scope Ratings