German regional borrowers are bracing themselves for what will be a challenging year ahead to fund their issuance programmes in the capital markets. Elevated spreads and an upcoming federal election, likely to trigger reform of the fiscal debt brake, add to the uncertainty.
The outlook for the German regional bond market was explored at the European sub-sovereign forum, hosted by OMFIF’s Sovereign Debt Institute in Frankfurt in November 2024. This event brought together senior funding officials at regional European issuers, along with investors and intermediaries for a series of high-level discussions.
‘It will be much more difficult than this year,’ said a head of funding at a German regional borrower. The first stumbling block is whether issuers will wait until after the election on 23 February to bring their first benchmark issuance of the year to the capital markets.
Can issuers wait?
‘It depends on how the spreads develop in January,’ said the funding head.
Spreads have been in flux as of late, not just in Germany but also across Europe and the US too. Earlier in November, the 10-year Bund swap spread entered negative territory for the first time, driven by the collapse of Olaf Scholz’s collation, a weak economic outlook, expectations of a higher supply of government bonds and the impending arrival of Donald Trump as US president.
‘Right now, we have very high spread levels for the German Laender space,’ said a senior funding official at another German regional borrower. He noted that the current spread levels were on par with what borrowers paid during both the 2008 financial crisis and Covid-19 pandemic.
The funding official stated that next year, the German regional borrower will issue slightly less compared to 2024, giving it flexibility to wait until after the election to issue its first benchmark of the year. ‘This would mean one less benchmark next year compared to this year,’ he said. ‘So it would be easier from an issuer perspective… We can even wait until March.’
Growing calls to loosen the debt brake
What happens during the elections in February will have major repercussions on how the spread outlook develops in 2025 for German regional borrowers. The big question is whether the fiscal debt brake (Schuldenbremse) – a contentious issue for many years, which caused to the dispute that led to the collapse of the collation government – will be finally loosened.
The debt brake was imposed in 2009 after the 2008 financial crisis to limit the federal government’s annual budget deficit to 0.35% of gross domestic product. This is also passed onto German states. But there are increasing calls to loosen the debt brake to allow for much-needed investments in areas like infrastructure and to stimulate the economy.
Those in favour of loosening the debt brake point to statistics to support their argument, with the debt-to-GDP ratio in Germany at around 62% – well below the euro area average. That ratio is far lower in some German states meaning that, in some cases, borrowers feel they have the capacity to borrow much more.
New leadership
The expectation is that Friedrich Merz, head of the conservative Christian Democratic Union, will succeed the Social Democratic Party (SPD) in February and loosen the debt brake, which requires a majority of two-thirds in both houses of parliament to be reformed. At the OMFIF forum, 62% of the participants said a reform of the debt brake would certainly occur in 2025.
In addition to the elections and Schuldenbremse, the other big talking point at the OMFIF forum was whether German regional borrowers should trade relative to KfW, following a much tighter spread between these issuers in 2024.
‘It’s very hard to say what the actual spread should be,’ said a debt capital markets banker. ‘Historically speaking, it’s always been somewhere between five to 10 basis points but over the last 12 months, it has sometimes been anywhere from zero to six basis points.’
The logic has always been that, while German regions and KfW have more or less the same structure – being one step removed from the sovereign – KfW is helped by its greater liquidity and explicit guarantee resulting in a spread differential. Only 25% of participants at the OMFIF forum said bonds from German sub-sovereigns should trade through KfW.
Burhan Khadbai is Head of Content, Sovereign Debt Institute at OMFIF.
