Industrial strength retail bonds

With the control of the same founding family assured for several generations, 'Mittelstand' companies were traditionally unreachable territory for private investors. However, for roughly the same length of time as London's Order Book for Retail bonds (Orb), Germany's eight regional stock exchanges have launched bonds aimed at private investors that are issued by Mittelstand companies. This indicates a general trend among smaller companies to diversify their sources of capital without threatening their basic equity base. At the same time, it might offer UK investors much greater choice of fixed-income options in the future, if a regular market maker can be found in London.

It is fair to say that the Mittelstand is unique to the German economic model and comprises 52 per cent of the country's economic output. It doesn't really equate to the small and medium-sized sector in the UK, because here self-employed artisans and tradesmen are counted into the figures - as a result the proportion of SMEs as a percentage of economic output tends to be exaggerated. To be genuinely Mittelstand means employing at least 20 people and making a direct contribution to the export economy. More than 60 per cent of all German workers are employed by family companies, a far greater proportion than any other advanced industrial economy.

The Mittelstand needs cash

A familiar refrain over the past five years is the extent to which smaller companies have been starved of credit while UK banks shrink their loan books and concentrate on building up capital. In fact, that was one of the main reasons that the London Stock Exchange (LSE) took the risk on forming the Orb market. It would be a mistake to think that German companies were any less squeezed by the crisis in the banking sector, as German banks proved to be no less dysfunctional in their lending practices; Deutsche Bank is the latest to be caught up in an off-balance sheet lending scandal.

Lending to Mittelstand businesses is profitable, but there might not be enough to go around for all the banks. For example, Commerz Bank reported that its Mittelstand division made operating profits of €1.6bn in 2012, more than the rest of the bank's operations put together. That is the exception, rather than the rule, as it is often jokingly suggested that there are more German banks than businesses to lend to, but at rates that are not competitive for businesses, which depresses margins in the long run. Alongside this structural problem, there is now the possibility that banks could get left behind if Mittelstand companies decide they have more funding options than simply turning up at the local Sparkasse and asking for a loan.

That option might now be the bond market after the banking crisis forced many finance directors to undertake a thorough rethink of how companies organise their capital structure should short-term credit suddenly become unavailable. In this context, bonds aimed at retail investors are simply a way of diversifying funding risk and Germany's regional stock exchanges have taken the lead in bringing the bonds to a ready market.

The bond options

The first point to make is that buying and selling bonds in Germany has always been considerably easier than in the UK, with investors able to walk into high-street banks and simply choose from a selection of bonds available on the market.

However, gaining access to the Mittelstand was also incredibly difficult for German investors until the Stuttgart regional stock exchange pioneered so-called 'Mittelstand bonds' aimed at retail investors three years ago. Frankfurt has since followed suit with a bond exchange of its own, along with Germany's other regional exchanges. The Stuttgart index for retail corporate bonds is still the most comparable to the UK Orb market and specialises only in bonds issued by small and middle-sized companies that are either privately owned, or have a large family shareholding.

As you can see from our table overleaf, the German bond market is significantly more diversified than the issues coming onto Orb. For instance, there are no property companies and the list contains well-known names such as airline company Air Berlin. Beyond that, the mix is eclectic, with a typical Mittelstand machine tool company like Durr competing for space with Royal Beach Spielwaren, a purveyor of upmarket paddling pools and trampolines. Secondly, the performance of the bond market appears to be much more closely watched than in the UK. For example, internet retailer getgoods.de was recently obliged to put out a statement after its bond price slumped to well below par - management said there was no particular reason for this.

The spread of risk in the German market is also far greater than UK investors will be used to when it comes to retail bonds. For example, the Stuttgart exchange has a rating system that measures the possibility of default within a particular year. For the eight riskiest bonds available to investors, the exchange reckons that the possibility of default at any one time is about 23 per cent.

That has already happened to solar power company Centrosolar, which defaulted on bonds issued on the exchange barely two months after listing them. Investors will get a debt-for-equity swap, but, according to the German financial press, the company plunged deep into the red in 2012 after a period of fierce competition with low-cost Chinese manufacturers. The obvious question is how Centrosolar ever managed to offer bonds to investors if its underlying financial situation was so precarious, which perhaps illustrates the German market's reputation for lack of transparency.

Still, there are some interesting-looking bonds on the market, with the main challenge being gaining access to market information that is mostly in a foreign language and also finding a market marker who can access price information. London market maker Winterfloods said that it didn't make a market in London for German bonds directly, although it can get access to prices through a deal with Close Brothers and fulfil buy or sell requests on an order basis. With that in mind, the following five bonds catch the eye and, usefully for investors, each bond listed in Stuttgart has a printable credit report prepared by the Creditreform ratings agency, which is where we draw our information.

Albert Reiff GmbH 7.25% 17 May 2016

The point of the M-bond class was to allow mid-sized companies to access new sources of capital. Albert Reiff is a classic example of a Mittelstand company. It is Europe's largest supplier of motorcycle tyres, which it wholesales across the continent. Chances are that most bikers getting their kicks on the A66 between Brough and Temple Sowerby will be using tires ultimately supplied by the company. The company's bond has a BBB- rating, which reflects the company's exposure to the currently volatile car market in Europe. However, the expectation that the market will improve is why the bond is tracking ahead of par at a price of 106p, giving a yield to maturity of 5.05 per cent, which points to the company being a core holding. The bonds are the only way for retail investors to access the company.

German Pellets GmbH 7.25% 9 Jul 2018

Alternative sources of fuel is a growth area in the energy sector as electricity producers and home owners try to move away from fossil fuels in order to meet carbon emissions standards. German Pellets specialises in alternative heating fuels, with offices in the US and Germany. Of the company's two available bonds on the Stuttgart exchange, the longer-dated issue carries less immediate capital risk as it trades at around par. The credit rating is slightly better than average at BBB, with the possibility of long-term credit risk given the fuel market could yet be revolutionised by cheap shale gas.

Mag IAS GmbH 7.5% 8 Feb 2016

Machine tools is another area in which German companies excel and the industry generally has benefited from China's rush to equip its factories. However, the picture has become cloudier as China rebalances towards consumption and capital orders have faltered - the last reported accounts showed a loss of nearly €52m. Consequently Mag IASm has had to restructure its operations by selling some of its US business and concentrating instead on its core markets. The company is so exposed to the business cycle that any increase in business investment from current low levels will benefit it in the short term. That is why the bonds trade at a relatively small discount to par and, at 96p, carry a thumping yield of over 9 per cent.

Mox Telecom AG 7.25% 1 Nov 2017

Mox Telekom is a developer of pre-paid phone cards for mobile phones, fixed net and internet telephony. The company employs approximately 170 workers and last year generated €5m profits on a turnover of €211m. There are €35m of Mox Telecom bonds in issue, with the smallest trading unit at €1,000. The bonds have drifted below par and now trade at an attractive yield to maturity of 7.7 per cent, or a 7.3 per cent spread over German government bunds. Telecoms has been shaken up by internet competition, with products like Skype and Facetime allowing very low cost long-distance communications. This is why the bonds attract a credit rating of BBB, reflecting fears over long-term market stability.

More & More AG 8.124% 11 Jun 2018

Moving further up the risk scale we have a B+ rated bond from internet clothes shopping specialist More & More. The company, which could be compared with Asos in the UK, supplies women's fashion to discerning customers. It is risky because Germany's service industry, particularly internet companies, is underdeveloped compared with the UK, which is why it attracts a relatively low rating. However, turnover hit €45m last year and the company posted a healthy operating profit of €4.45m. Best of all, the bonds are still priced at par, so investors have no yield-to-maturity capital risk over the lifetime of the bond. The coupon is also among the best available on the German market.

Stuttgart Mittelstand bonds