Sebastian Zank, managing director in corporate ratings at Scope, looks at the Schuldschein segment’s fortunes so far this year in conversation with Dierk Brandenburg, head of credit and ESG research.

Dierk Brandenburg: The Schuldschein, Europe’s leading private debt market, has been active for years. With turmoil on public markets, how is the segment doing? Is it open?

Sebastian Zank: The Schuldschein market is very much open. The market tends to come into its own in turbulent times such as the global financial crisis and euro crisis. Investors turn to Schuldschein where conditions do not deteriorate in the same way as they do in the public markets. The first half of this year is no exception. In 2022, we have seen increased activity after a couple of subdued years, with plenty of deals in the pipeline. The volume of announced deals is up at around EUR 15bn so far compared with full-year volume of around EUR 20bn in each of the past two years.

DB: The ESG-linked compartment of the market is thriving, isn’t it?

SZ: Yes indeed. Year-to-date ESG-linked Schuldschein volume has exceeded the entire volume that we saw in 2021. This includes some jumbo deals: EUR 800m from Belgian construction materials company Etex Group, EUR 750m from Germany’s flavour and fragrance producer Symrise AG, EUR 655m equivalent from Swiss-French construction materials company Holcim Ltd. and EUR 600m from Swiss power utility Axpo Holding.

Figure 1: ESG-linked SSDs 2022 YTD surpass 2021 FY volume
(project-based and target-based SSDs linked to ESG factors)

2022 YTD comprise settled deals and deals which are currently in the placement phase
Source: Scope Ratings

Overall, the share of ESG-linked Schuldschein placements easily exceeds the 40% mark so far in 2022 (42%) compared with slightly less than 30% in 2021. Every third Schuldschein transaction is linked to ESG, which demonstrates the easy integration of ESG factors into the documentation and significant market appetite. The Schuldschein market is well ahead of the public bond market where only 32% of volume is ESG-linked year-to-date.

DB: Is this mostly green issuance?

SZ: No, sustainability-linked Schuldschein are most common, though there are some green and social-linked deals.  Not every company is able to dedicate bond proceeds to a specific green or social project, so it is easier to embed broader key performance indicators (KPIs) linked to sustainability into the documentation.

DB: What are the typical KPIs?

SZ: Most of the deals are simply tied to an ESG rating from an external provider. If there are quantitative KPIs, they tend to relate to greenhouse-gas emissions or other indicators such as training, water usage, waste recycling, and work safety. IT developer All for One Group has taken an innovative approach, placing a Schuldschein embedded with an ‘ESG-bridge’ that allows the company to tie the interest rate retroactively to a yet to-be-defined ESG-related KPI.

Figure 2: ESG ratings, emissions: most popular KPIs in SDG-linked bonds (frequency*)

* One SSD deal can have multiple KPIs/SDGs
Source: Scope Ratings

DB: Of course, ESG ratings are increasingly under scrutiny and can differ widely for the same company. Do we need more objective KPIs?

SZ: My preference would be for ties to measurable KPIs because they provide more substance and credibility – and help counter allegations of greenwashing.

DB: How significant are the coupon steps in these deals? Are they a real incentive?

SZ: My blunt opinion is that coupon steps do not provide much of an incentive and are mainly about marketing. When most of the deals only have a penalty between 2.5 basis points and 5 basis points, it is just smoke and mirrors. Coupon steps of this order do not really matter in terms of the issuers’ interest burden. It is a very similar situation in ESG-linked bond market, too. The only exception is Swiss utility Axpo which is said to have a 25bps penalty if the embedded ESG target is missed.

DB: What is behind the increased demand for ESG-linked Schuldschein?

SZ: Again, the story is very similar to broader market. Investors want or are required to put money into ESG-linked assets as we have seen in public market where the demand for ESG-linked bonds is higher than for conventional bonds.

DB: The Schuldschein is a relatively illiquid, buy-to-hold market, but is there any sign of an ESG premium or “greenium”?

SZ: Our analysis has shown there is a premium for ESG-linked bonds, but for less liquid Schuldschein we do not have comparisons with either bank loans or bonds, so we cannot tell.

DB: Who are the main issuers accessing the market with conventional or ESG deals?

SZ: It is a very heterogenous set. Utilities, capital goods and real estate companies are as dominant in the Schuldschein segment as they are in public markets given their financing needs and asset intensity. But unlike public markets, the range of issuers is wide, from tiny, small-cap companies to large multinational conglomerates, as are deal sizes, which range anywhere from EUR 25m to EUR 800m.

DB: Private markets tend to come under greater scrutiny in difficult economic times – positions are not marked to market, which goes for equity and for traded debt – so how do you judge credit quality in the Schuldschein segment? Do we expect more defaults?

SZ: Defaults were an issue after the flurry of small and medium-sized companies which placed Schuldschein debt between 2014 and 2017. But investors and arrangers have learnt their lesson and have become more discerning. There is always a possibility of defaults, but the market is essentially the preserve of investment-grade and crossover candidates in BB range.

However, issuers face a delicate mix of inflation, rising interest rates, supply chain constraints and lower government subsidies post-Covid. It will become important to monitor the pricing power of smaller issuers on products/services and their refinancing activities to avoid a material deterioration of their credit strength. Overall, though, it is not easy to have a complete overview as the Schuldschein is largely an unrated segment with plenty of small issuers. We have to trust the reputation of the market.