As the euro corporate bond market prepares to welcome a price-insensitive investor to the stage, borrowers have been quick to feed the hunger for credit. But behind that backstop bid from the ECB lie plenty of unknowns.
With Europe’s economy wallowing in a prolonged low growth, low inflation cycle, it was no major surprise to bond market practitioners when the European Central Bank announced in March another round of attempts to stimulate the eurozone towards its 2% inflation target. What was more of a surprise, however, was the extension of the central bank’s Asset Purchase Programme (APP) to include corporate bonds.
On March 10, the ECB announced that it was lowering deposit rates further into negative territory and, as of April 1, expanding the combined monthly purchases under the APP to €80bn from €60bn. For the first time, however, the remit of the APP would be widened to incorporate euro-denominated bonds from Europe’s corporates in a Corporate Sector Purchase Programme (CSPP).
“Investment-grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets eligible for regular purchases,” said the ECB in a press release at the launch of the programme. “The CSPP will further strengthen the pass-through of the Eurosystem’s asset purchases to the financing of the real economy.”
There was very little other information for the market to digest other than that the buying would commence towards the end of the second quarter. Nonetheless, the prospect of another major investor joining the demand side for European corporate bonds – a price-insensitive one at that – had an immediate impact on the market.
“It’s a game-changer,” said Martin Wagenknecht, head of DCM origination for Germany, Austria and Switzerland at Societe Generale CIB.
At the beginning of 2016, European credit markets were suffering from the volatility associated with fears for the China economy and a precipitous fall in oil prices. The situation had begun to improve leading up to the ECB meeting in March as oil started to recover and Japan soothed the markets by adopting negative interest rates. That change in sentiment created a fertile backdrop against which the ECB announced its own monetary-accommodative plans.
Investors quickly stepped back into the market in the belief that credit was the place to be – for the foreseeable future, at least.
“Overall investor demand is resilient,” said Christoph Rieger, head of rates and credit strategy at Commerzbank. “Even on risk-off days, the cash market often continues to tighten.”
The strength in demand is reflected in the performance of the iBoxx Triple B index. In mid-January, it was trading around the 190bp level, but by March 10, it was closer to 150bp and was 115bp by mid-April.
“Not all of that tightening is purely due to the ECB’s announcement, but it clearly impacted it and demonstrates the underlying strength of demand for credit,” said Marc Mueller, head of DCM origination for Germany, Austria and Switzerland at Deutsche Bank.
The strong performance in Triple B names has been closely replicated throughout the credit markets, with even debt not expected to be included in the scheme, such as corporate hybrids and bank bonds, also benefiting from the dramatic increase in demand. Securities from issuers more likely to make an appearance on the ECB’s buy list have outperformed the rest of the field by some 7bp, according to calculations made by Commerzbank.
The immediate reaction to the ECB’s announcement comes in advance of full disclosure as to the workings of the programme and has left the market speculating as to what it will look like.
“Will they be restricted to size, will they follow the indices, will they include private placements and, if so, how will they go about the credit assessment?” asked Wagenknecht.
But with an outstanding universe of likely eligible bonds estimated at somewhere between €550bn and €650bn, the additional €20bn of monthly asset purchases is not expected to all be targeted at corporate bonds.
“I’d be surprised if they communicated ex ante the share of corporate bonds to be purchased as part of the overall allocation,” said Rieger. “I doubt whether they will make the same mistake as they did with covered bonds, where they were unable to meet targets for the second programme. They will go to where they can find the liquidity.”
And there is a fair chance that the hunt for liquidity will likely lead them into the primary market, said bankers. It will be a struggle to see how the ECB can fulfil its requirements in secondary when there is a lack of inventory in the market.
Mueller agreed. “When you look at liquidity, the only meaningful volumes are in primary.”
That lack of liquidity in secondary draws a comparison with events in covered bond and Pfandbrief markets. Here, practitioners have long been animated as to the actions of the ECB and its impact on pricing efficiency.
The Pfandbrief sector is heavily distorted by the presence of the ECB. Even for new issues that are undersubscribed, there will eventually be a strong bid from the central bank, said bankers, making it difficult to establish the right price for new issues as spreads in secondary are so skewed.
The impact on corporate bonds is unlikely to be as pronounced as the market is less commoditised, but there are undoubted implications for investors, borrowers and liquidity.
“Market liquidity is already at low levels due to regulatory pressures, such as capital charges for market-making,” said Victor Verberk, head of investment-grade credits at Robeco. “The CSPP will probably not make things better.”
Knowing there is always a buyer in the secondary market may be positive for sellers but it makes investing more difficult. Those investors that are able to will look longer out on the curve, move further down the credit spectrum and consider buying debt in other currencies in order to generate returns. Although there are plenty of investors that are constrained by their mandates.
“We try to resist buying ever more credit risk (like high-yield in investment-grade portfolios),” said Verberk. “The credit cycle is slowly turning and we like to be contrarian.”
With demand for European credit supplemented by the region’s central bank, the market looks primed for borrowers to raise debt, and to do so at reduced prices, which is good news for Germany’s frequent borrowers in the auto industry, for instance.
Some borrowers have been quick to take up the opportunity.
“March was a very strong month in terms of new issuance,” said Mueller. “There was also a decrease in new issue premiums – something that issuers always appreciate.”
Issuance volumes of euro-denominated corporate debt, which had been lagging behind levels seen in 2015, have picked up considerably since the ECB’s announcement was made.
“In January, the corporate euro new issue market was running at levels some 65% behind those seen in 2015,” said Mueller. “By the end of February, as markets improved, primary markets had begun to catch up, and by mid-April, following the ECB announcement, we are only down 11% year-on-year.”
As well as more supply and smaller premiums on new issues, there has also been a tendency to lengthen duration.
“Since the announcement in March, we’ve seen new issues move out from tenors of five to seven years out to ones of seven to 10 years plus,” said Dominik Huhle, head of the DCM/RSG team for northern Europe at Barclays, which acted as lead on a recent 12-year deal for German gas supplier, Linde.
The scene would seemingly to be set for an onslaught of new issues to come to the market. Underlying demand for credit is unquestionable and that demand is soon to be supplemented by a new major player. The fall in rates and spreads should provide market access to lesser-known borrowers and there is now a choice for corporates that may have previously relied on bank lending. There are also obvious incentives to take advantage of current conditions to bring forward any funding that needs to be done.
Yet bankers are not predicting an enormous wave of borrowing.
“I don’t expect to see much more issuance in terms of volume,” said Wagenknecht. “Cash positions within the larger German corporates are good, so there is no pressing need for them to visit the market. And with yields so low in short-end deposits, there is no incentive to pre-fund.”
Huhle agreed. “I don’t expect to see a dramatic increase of funding activity because of the ECB programme. Funding conditions in the European market for corporates have been good for some time. Unless there is a timely need for funding or a significant change in fundamentals, why would an issuer come to the market now if they decided against it six months ago?” he said. “Particularly if you consider the negative cost of carry.”
The new paradigm, however, will undoubtedly present the less-regularly seen corporates with access to the public markets, such as those from the Mittelstand and from the peripheral euro markets. It will also accommodate issuance from outside the region. US borrowers, for instance, have been a common feature in the market over the last year with so-called reverse Yankees.
“With overall spreads tightening, everyone in the investment-grade space benefits,” said Huhle. “Whether they are included in the ECB’s programme or not.”
Longer term, however, there are some concerns as to the damage the ECB’s buying could inflict on the relationship between borrower and lender.
“Corporates in Europe have spent a great deal of time to develop a well-diversified investor base and they won’t want to give that up for the ECB,” said Huhle. “Borrowers cannot rely on just one investor.”
That sentiment is particularly true when, at some point in the future, the ECB’s buying comes to an end.
There are also worries as to whether the policy achieves its purpose in passing on liquidity into the real economy. Quantitative easing in the United States, for example, although not extending to corporates, has led to tighter credit markets and prompted some bumper trades last year, but in some cases the motivation to launch was for M&A purposes or share buybacks, rather than fostering growth in the economy.