In times of aggravated credit financing and continuing volatility in the markets, issuing high-yield corporate debt to retail investors can prove a feasible way of accessing money—for small, medium and even large enterprises. Historically, the purchase of individual bonds was beyond the reach of most private investors because the minimum amount needed to trade was typically € 50,000 (equivalent) or even € 100,000 (equivalent), but the retail bond market now provides direct access to corporate bonds for trading in retail-friendly increments of around € 1,000 (equivalent). Making corporate bonds available for lower amounts is a response to strong private investor demand. For instance, Schaeffler Group’s1 € 300 million 6.75% senior secured notes offering in denominations of € 1,000 to retail investors and an additional approximately € 26 million 6.75% senior secured notes offering to Schaeffler employees in Germany, which both completed in July 2012, serve as a paradigm for a high yield bond offering issued to retail investors. The transaction has showcased an innovative structure that combines an offering to retail investors in Germany and Luxembourg with a separate employee offering, thereby also resolving concerns that generally arise in the context of retail offerings. As the first single B rated credit high yield bond offering directed at retail investors, the deal is truly a market first.

By Gernot Wagner / Susanne Lenz (Reference: CapLaw-2012-39)

1) Introduction

When access to traditional bank loans is progressively becoming difficult, even for seasoned issuers with good credit ratings, tapping the capital markets becomes a viable alternative in light of accretive financing needs. High-yield bond offerings, though still mostly centred in the United States, are proving more and more popular in Europe. In Germany, high yield bonds have not only been issued to institutional investors but over the last years increasingly to retail investors as well. Some of the local exchanges have put up retail bond platforms on which issuers can sell their bonds to retail investors without the costs involved in having an investment bank underwrite the issue. The Frankfurt Stock Exchange, for instance, fairly recently launched a retail-segment for bonds (Entry Standard), thereby providing a platform to sell bonds to retail investors. Similar platforms exist at other German stock exchanges. Admission to bond trading in the Entry Standard, for instance, is fast and easy: The application for inclusion in exchange trading has to be filed by a registered trading member of the Frankfurt Stock Exchange, who will also monitor compliance with transparency requirements and act as central interface between company and exchange. Before the issue is launched, the company has to submit and publish an approved securities prospectus, a concise company profile with information on the securities to be issued, a corporate calendar, audited annual financial statements, certain financial ratios, proof of creditworthiness by an approved rating agency as well as various corporate documents. An appointed and assigned Deutsche Börse listing partner will assist the company in structuring the issue in terms of scale of emission, maturity and interest rate calculation. There are no formal requirements regarding the securities other than a maximum denomination set at € 1,000 and the prerequisite that the debt must not be subordinated. After the issue date, companies are obliged to submit annual and half-yearly financial statements, annual follow-up ratings and certain balance sheet ratios. In addition, issuers are required to disclose sensitive information that could influence the bond price.

Besides the fact that the German retail market is largely untapped, advantages of trading bonds on retail market platforms from the issuer’s perspective are obvious: The lack of formal requirements and less stringent follow-up obligations, the fact that the issue does not need to be underwritten by an investment bank, established trading platforms and widespread prevalence of online transactions, retail-friendly standardizing, low transaction costs, subscription at issue price and transparent secondary market trading.

From an investor’s perspective, advantages are equally obvious: Bonds offer higher returns than cash to compensate for interest rate and credit risk. The money can be moved in and out of the corporate bonds without any penalty payments. Whenever the investor wishes to cash in the bond he will receive the market price.

Nevertheless the advantages do come at a cost. The greatest concern raised by high-yield bond retail issuances is the lack of protection of retail investors who carry the credit risk. No strict tests are applied to the issuer and only few key financial figures are published. Credit ratings can be obtained from small regional rating agencies. Documentation is kept to minimum without extensive covenant-protection. Retail investors may not even appreciate the risks involved in speculative-grade investment. Investors need to be careful to perform due diligence on the business in which they are contemplating investing, including examining the issuer’s market share, its relationship with customers and suppliers, its brand image, the prospective use of bond proceeds, the stability of cashflows and the service of debt.

In addition, secondary market prices of corporate bonds swing significantly and it might prove difficult to find relevant trading information. Trading prices of bonds fluctuate according to the balance of supply and demand and bond prices tend to drop when interest rates rise. Obviously, this will not come into play if the investor holds the bond to maturity.

2) The Schaeffler Precedent

a) The High Yield Retail Offering

In February 2012, Schaeffler AG already issued € 2.0 billion high yield senior secured notes in four tranches with a mix of currencies and maturities, a benchmark offering. The precedent-setting deal included a pari passu structure with a unique dollar-for-dollar voting mechanism. The bond was issued in minimum denominations of € 100,000 to institutional investors.

The latest bond, which completed in July 2012, however, was issued in minimum denominations of € 1,000. Contrary to market practice, it contained an extensive covenant package, i.e. included the same covenants as the February 2012 bond, thereby resolving all doubts about the lack of protection of retail investors.

Over the last three years, more than two billion Euros have been placed directly with investors. These retail bond offerings mostly had smaller deal volumes compared to the Schaeffler deal volume, between € 50–100 million and generally did not include any covenants. Yet, unsecured bond offerings are risky investments from the investor’s perspective and institutional investors are not necessarily keen to participate in such deals. In contrast, the covenant package on Schaeffler’s second high yield offering included a full security and collateral package and was picked up by retail investors as well as institutional investors. The transaction might signal the start of a new trend whereby high yield issuers that have traditionally only tapped the institutional market, could now move away from the € 100,000 denomination and instead choose to go down the path of having the prospectus approved by a regulator in order to tap the high yield retail demand.

b) The Employee Offering

In addition to what has been set forth above, the game-changing deal also provides a blue-print for an employee offering for European Companies with a similarly large employee base. Schaeffler employs approximately 29,000 individuals in Germany. Theseindividuals were given the opportunity to subscribe for the bonds (up to € 50 million) once the retail tranche had priced. Had it been structured differently, the employees would not have known the coupon prior to subscribing the bonds and, therefore, would have had the same risk as other institutional and retail investors. The combined transaction—the entire transaction was treated as a single offering—was structured as a € 200 million offering, with up to an additional increase of € 300 million and a further increase of up to € 50 million for the employee offering. After a two-day offering period for the retail tranche, the deal priced at 6.75%. Employees could then subscribe the bonds from July 6, 2012 until July 13, 2012 at the same price, i.e. the employees were given a week to set up securities accounts, receive sufficient education from the company on the investment and subscribe for the bonds.

c) Regulatory Issues

The transaction demonstrates to the market that it is possible to obtain regulatory approval of a complex offering of this kind. This is despite the fact that the Luxembourg regulator (the Commission de Surveillance du Secteur Financier, or the CSSF) does not have extensive experience with traditional high yield bonds. Generally high yield bonds are not offered to retail investors and hence do not require approval by European regulators. The approval process therefore took significantly longer than expected and should improve in future deals with a similar structure.

The Schaeffler deal had 28 guarantors. The Prospectus Directive requires companies to publish the financials of the guarantors as well as any risk factors specific to each guarantor which would have added hundred of pages to what was already a 496-pagedocument. A waiver was obtained to use the consolidated accounts instead of individual financial statements of each guarantor.

3) Conclusion

Given the continuing volatility in the markets, Schaeffler AG’s high yield bond offering to retail investors and employees can be considered a blue-print for other issuers to tap not only the institutional markets, but also have access to retail money. With savings rates at a record low and nervousness about the stock market, individuals with as little as € 1,000 will be able to access the corporate bond market. Other fixed income assets look by far less attractive. Though financial markets remain stressed, high yield corporate bonds have proven surprisingly resilient with default rates well below the historical average.