BaFin

Topic Consumer protection Mittelstand bonds: Not transparent enough as an investment for consumers?

Date: 02.11.2017

A few years ago, the financing of small and medium-sized companies experienced a veritable boom as the issuance of “Mittelstand bonds” took off. Many of the bonds issued at the time will mature in 2017 and 2018. As a consequence, new Mittelstand bonds are being offered in order to refinance them.

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In this situation, many investors have to decide whether to put their money into products of this kind. What are the characteristics of this asset class? Are there any risks and opportunities to be aware of? And which sources of information are available for making an investment decision? This article is meant to give a short overview.

The rise of the “Mittelstand bond”

In the course of 2010, several exchanges in Germany established segments that were dedicated specifically to corporate bonds issued by small and medium-sized companies. Mittelstand firms now had a new way, in addition to regular bank loans, of financing investments and refinancing their liabilities. Furthermore, Mittelstand bonds offered investors an interesting opportunity at a time when the returns of traditional investments were receding.

As a result, Mittelstand bonds were very popular in the years that followed. By 2013, BaFin had examined almost 150 securities prospectuses for Mittelstand bonds. The fact that “Mittelstand” stands for seriousness and a down-to-earth attitude in German certainly played its part.

Mittelstand bonds were usually sold in denominations of €1,000. This had the effect that many retail investors subscribed to the bonds as well.

Decline of the market

However, the demand for Mittelstand bonds receded from 2012 to 2015 as multiple bonds defaulted. This trend continued in 2015 and 2016. At the same time, fewer issues came to market. From 2014 to 2016, BaFin approved only 71 new prospectuses for Mittelstand bonds.

Of the Mittelstand bonds that have come to market since 2010, a good many have been affected by insolvencies or delayed payments. In the worst case, this can result in a total loss for the investor.

Refinancing

For some time now, there has been an increase in the number of offers to buy Mittelstand bonds which are intended to refinance existing bonds. As mentioned above, this is partly due to the fact that a large proportion of the bonds placed some time ago are coming up for redemption during 2017 and 2018.

In some cases, the issuers of these bonds have very different approaches in such refinancing operations. Some issuers whose bonds were coming up to maturity managed to raise funds by issuing new bonds over the last few months. This enabled them to redeem the old bonds. Other issuers made their investors an offer to extend the maturities of their bonds by several years, often at a reduced interest rate. Others are also giving investors the opportunity to convert their bonds into shares or other debt instruments. Redemption is thus avoided or postponed to a future point in time.

Investors should, however, scrutinize the reasons for the refinancing of a bond. This could be more attractive terms in the capital market, but it could also be that the company is not in a position to reduce existing liabilities on its own or from other sources, e.g. a bank loan.

DefinitionsImportant terms

Corporate bond: A debt security issued by a company for a predetermined period of time and at a predetermined (fixed) interest rate, with the nominal amount being payable on maturity.

Mittelstand bond: A special form of corporate bond issued by a small or medium-sized company. The terms of an issue can differ from case to case. The volume of an issue is typically between €3m and €20m. The average term to maturity is five years, with an interest rate of between 3.5 percent and 8 percent. Mittelstand bonds are usually issued in denominations of €1,000.

Issuer: The company that issues the bond.

Securities prospectus: Securities prospectuses contain information in respect of the issuer and the security which is necessary to enable the reader to make an informed assessment of the assets and liabilities, financial position, profit and losses, and prospects of the issuer as well as of the rights attaching to such a security. Companies that offer bonds to the public are obliged to submit a securities prospectus to BaFin. BaFin approves the prospectus if it meets the minimum information requirements pursuant to the German Securities Prospectus Act (Wertpapierprospektgesetz - WpPG) and the EU Prospectus Regulation, and if it is comprehensible and consistent. BaFin does not, however, check the issuer’s integrity or the intrinsic value of the product.

Covenants: Clauses in which the issuer makes a commitment to protect certain bondholder’s rights.

Interest coverage ratio: Indicator that shows the ratio of interest expenditure to operating profit.

Benefits and risks

The benefit to Mittelstand bonds is obvious: in the ongoing low interest rate environment, they are first of all an attractive alternative to conservative asset classes. Compared to the shrinking yields of, for instance, current and savings accounts and private pension insurance schemes, Mittelstand bonds offer a significantly higher return.

But this advantage should not blind investors to the risks that are inherent to Mittelstand bonds. On the contrary: the higher return should be considered an indicator of this increased risk. It is therefore important that investors are aware of the risks of Mittelstand bonds.

As shown by many defaults, Mittelstand bonds are a speculative investment. There is a risk that an issuer’s insolvency triggers a default, rendering the issuer unable to repay either the expected interest or the full amount of the money invested. With a bank loan, a company may be required to provide creditors with collateral, which is not the case with Mittelstand bonds. While covenants are agreed in many cases, the issuer is still free to determine the details of any such protective clauses.

Furthermore, it is quite possible for the placement of a bond not to be completely successful. As a result, the issuer may not receive the funds required to make a planned investment or complete a refinancing. Equally, the issuer may borrow more capital at a later date and thus become more indebted, which may make it more difficult to pay interest and repay principal.

It should also be borne in mind that the liquidity of the market for Mittelstand bonds can be limited because of the comparatively low issue volume. Supply can therefore exceed demand for these bonds, and there is a risk that selling them before the maturity date may not be possible, or might only be possible at a considerable loss.

Consumer advice

Considering these and other risks, investors should carefully examine the information at hand before subscribing to a Mittelstand bond. They should make sure that they understand all the characteristics of the selected product and gather sufficient information about the issuer. Those who have any questions or doubts may find it useful to seek advice from an expert, such as an investment advisor or a consumer advice centre.

In particular, investors should only invest amounts that they can afford to do without because of the risk of a total loss. It also makes sense not to concentrate all available funds in one investment but to spread them over various investments and asset classes.

Sources of information

One important source of information is the securities prospectus, whose publication is always compulsory. Prospectuses are often published on the internet, for instance, on the issuer’s website. In addition, BaFin provides access to all the prospectuses it has approved on its website for twelve months in each case. Investors who consult an investment advisor can also find information about the type of financial instrument and the risks associated with it in the product information sheet which, pursuant to section 31 of the German Securities Trading Act (WertpapierhandelsgesetzWpHG), has to be handed to them in good time before a transaction is concluded. In addition, they should look at the most recent annual accounts and gather background information on the issuer.

However, it is also advisable to exercise caution when examining rating reports. Firstly, there is evidence to suggest that some ratings did not fulfil investors’ expectations in the past. Secondly, ratings often refer to the issuer rather than to a product. The risks of a particular security, such as the possible subordinated rank of certain creditors in case of an insolvency, may be disregarded in the evaluation. Nevertheless, it is still worth reading the rating report as it may contain additional information.

At a glanceWhat investors should look out for

When examining information sources, investors should pay attention to the following items in particular:

  • Interest rate
  • Issuer
  • Key figures
  • Business model
  • Use of proceeds

Important information

Investors should compare the interest rate of the individual bond with the current market rate and the risk-free interest rate in particular, which is currently around 0 percent. If the bond’s interest rate is significantly higher, this may indicate that the investment carries a particularly high risk.

It also makes sense for the investor to be aware of who the bond issuer is. If, for instance, a parent company acts as the issuer while its subsidiaries are responsible for the operational business, the investor needs to be aware of the fact that the creditors of the subsidiaries are usually given priority should any payment difficulties arise. The investor’s money is returned only if there are any funds left after the claims of all priority creditors, e.g. banks, have been satisfied.

Investors should also have a close look at the issuer’s key figures. The balance sheet and the profit and loss account contain various important data that can be helpful in assessing liquidity. If the interest coverage ratio is higher than 1, for instance, this may indicate that the issuer is able to pay interest with operating profit without having to make use of its equity capital. It is also advisable to compare several annual accounts. Difficulties arise when balance sheet items, such as the cash balance, turnover or receivables, vary greatly or when key figures are hardly comparable because of new non-recurring items. Investors should also supplement their research by looking closely at the issuer’s business model. For instance, they should assess whether the business model is plausible.

Finally, investors should, with the help of the securities prospectus, examine what use the issuer intends to make of the funds raised. A bond tends to be riskier if the amount raised is to be used not only for investments but also, or even exclusively, to refinance existing liabilities. Caution is also warranted if the prospectus does not contain such information because the issuer does not yet have any specific intentions (blind pool risk). In such a case, the investor may find it almost impossible to gauge whether the issuer is making good use of their money and how safe it is to count on the pledged payments of interest and principal.

Authors

Dr Mira-Caroline Strohe
BaFin Division for Consumer Trend Analysis and Consumer Education

Stephanie Zender
BaFin Division for Consumer Protection relating to Insurance and Complaints

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