Lame duck learns to fly
The launch of the ECB’s quantitative easing programme had the desired effect on the markets, pushing yields down and offering room to breathe, while also diverting investors into riskier assets.
It was the best of years, it was the worst of years. It was the age of constancy, it was the age of disorder. Since the European Central Bank announced the launch of its long-awaited €1.1trn quantitative easing programme in late January, the markets haven’t quite known what to do, swinging wildly first one way then the other like a punch-drunk boxer.
At first, stimulus offered the market room to breathe and grow. QE was well-flagged and well-received. After its official launch in March, bond prices rose sharply. Yields, notably on German Bunds, fell to fresh historic lows, turning negative on some shorter tenored debt. Issuance rose in lockstep, with corporate debt sales totalling €176.9bn in the current year to May 26, up 31% on an annualised basis, according to Thomson Reuters data.
Most corners of the market improved versus 2014, bar sovereign debt issuance, which was virtually flat on last year’s data over the same period. That constituted less of a surprise, given that stimulus was designed, said Charlie Diebel, head of rates strategy at Aviva Investors, “to make government bonds unattractive for investment, so money flows into equities and also into the provision of credit to the real economy”.
True to form, yields remained grindingly low well into the fifth month of the year. On May 7, Spain sold €885m worth of five-year bonds with an average rate of return of ‒0.286%, the first time Madrid had printed medium-term debt with a negative interest rate since the onset of the eurozone debt crisis. Daily volumes in eurozone government bonds were around a third higher than normal in the first quarter of 2015, according to MarketAxess.
Stimulus also successfully re-engaged investors with the concept of risk, diverting them “away from core government bonds and into riskier assets such as peripheral European government bonds and corporate bonds”, said David Zahn, head of European fixed income at Franklin Templeton Investments. In the year to May 26, the volume of corporate hybrid prints rose more than 50% year-on-year, reaching €13.14bn, according to Thomson Reuters.
Search for yield
Portfolio flows into developing market securities hit US$35bn in April, with most of the fresh capital being diverted towards Asia and equities, according to the Institute of International Finance.
“The impetus behind lowering rates even more seems to be attracting foreign issuers into this market and forcing investors in Europe to go along the credit spectrum and look for things that provide higher yield,” said Peter Noble, a partner at Norton Rose Fulbright.
“You’ve seen an acceleration in corporate hybrid issuance and high-yield debt issuance across Europe. With ultra-low rates, people will buy anything that offers a decent return.”
Maturities stretched in lockstep with stimulus. Peripheral eurozone sovereigns found themselves issuing debt maturing in the late 2040s. The tale was the same told last year, when monetary stimulus and ultra-low rates set in motion a desperate hunt for yield. The only difference, it seemed, was the source of the stimulus, with Frankfurt replacing Washington.
Indeed, it was hard to think of a more stunningly effective and simple riposte to those who believed the eurozone to be a permanently lamed duck.
Stimulus has, said Aviva Investors’ Diebel, “had a profound effect in terms of yield compression at the front end of the curve. But equally the recent correction in prices, and the increase in term premia, highlight that there is a degree of growing belief that over time the QE policy will work and gradually reflate the economy.”
Along the risk curve
Marcus Svedberg, chief economist at emerging market investment manager East Capital, said the search for yield was “pushing investors further out on the risk curve. The fact that not only developed market sovereign bonds with short maturities but also longer maturities and emerging market sovereigns are being sold at negative rates, are good illustrations of this trade”.
The latter point may offer a touch too much hyperbole: most eurozone states are still blighted by low growth and troublingly high unemployment, notably when it comes to younger workers – a point made by ECB president Mario Draghi at a May meeting of central bank officials in Portugal.
Ultra-loose monetary policy can only do so much, Draghi said, urging his sovereign peers to unleash a new round of structural reforms in order to realise the region’s “untapped potential”.
One clear and immediate benefit of stimulus was its success in unleashing the region’s bond markets.
“This was probably the best time ever in the eurozone to issue debt – and certainly since the financial crisis,” said Jerome Legras, head of research at Axiom Alternative Investments, which invests in securities issued by European financial institutions.
In the early months of the year, blue-chip corporates lined up to print euro-denominated bonds in an effort to lock in record-low rates. The list included regular issuers such as Germany’s Volkswagen, but also ranged across the US corporate universe, including such diverse names as Coca-Cola, Berkshire Hathaway, and pharma major Bristol-Myers Squibb.
Despite a slowdown in euro issuance by US firms in late April and early May, Eric Cherpion, global head of DCM syndicate at Societe Generale, believes this theme is here to stay.
“US corporate sales in the first quarter were not purely” due to record-low rates, he said. “You’ll see US firms comprise between 20% and 25% of all euro-denominated corporate debt volumes this year, against 10% in most years, with the figure stabilising at that level heading into next year.”
For many issuers, the only lingering question remained what to do with all that money.
“If you have financing needs – say, if you were planning to expand into a new emerging market – then you have an excuse to raise capital,” said Axiom’s Legras. “Even if you don’t, there are always share buybacks to do. From a purely financial point of view, thanks to stimulus, there was no good reason for issuers not to print fresh debt. With rates at the lowest level ever across the eurozone, the decision to print bonds seems a pretty easy one.”
But then the market turned. Sometimes when this happens, there’s a trigger event – witness BP’s £7.2bn (US$11.3bn) 1987 follow-on equity offering, which presaged Black Wednesday. This time the market simply seemed to hit a wall.
Longer-dated prints became harder to sell. A few sales offering chunky yields struggled to get off the ground. On May 14, Italian construction firm Condotte d’Acqua postponed a high-yield sale after a week of hectic marketing, despite scaling it down by a third and upsizing the yield.
“A lot of the selling in the European market was driven by American investors, worried by losing profit in a higher US interest-rate environment,” said David Owen, chief European economist at Jefferies. The market had also struggled to absorb the surge in new euro-denominated bond sales.
“Indigestion suggested that issuers printed too much debt, too quickly. Another factor was higher German inflation, which served to spook investors,” Owen said.
“If you have financing needs – say, if you were planning to expand into a new emerging market – then you have an excuse to raise capital. Even if you don’t, there are always share buybacks to do. From a purely financial point of view, thanks to stimulus, there was no good reason for issuers not to print fresh debt. With rates at the lowest level ever across the eurozone, the decision to print bonds seems a pretty easy one”
Ten-year German Bund yields, having ground to record lows, suddenly surged, with equivalent-maturity Italian and Spanish yields also spiking.
To Aviva Investors’ Diebel, the early-May sell-off (which hit all major bond markets) highlighted the market’s underlying volatility.
“It has been a year of two halves,” he said. “After QE was introduced, the market was looking pretty good. Then came the correction. Suddenly, investors were looking at deals with far greater scrutiny.”
One notable shift since the dark days of early May has been an antipathy towards longer-dated bonds. Issuers had begun to take yields to ever-longer ends of the curve – to places, noted one debt capital markets banker, “where investors weren’t even remotely interested. Investors were being asked to buy 15-year bonds with yields well below 1.5%. And Bunds were offering a handful of basis points at a time when other factors supporting a low-yield environment – a weaker US dollar, a stabilising oil price – were going into reverse.”
So what can the debt markets expect next? Some fear a sustained lull in eurozone bond issuance. That would explain the ECB’s announcement that it would increase its rate of asset purchases until mid-July, before paring back purchases through the summer months. Jefferies’ Owen tips bond issuance in the eurozone to ebb going forward.
“Issuers have frontloaded debt, so there is less to print in the second half of the year, which is also another argument in favour of us seeing greater spread convergence,” he said.
Others, not unreasonably, expect debt issuance to simply and quietly tick up again as we head into the second half of the year.
“Yields are still very low so issuance still looks very appealing,” said Aviva Investors’ Diebel. “I don’t think we need to worry about QE maturing any time soon. We have another 15 months of buying before this programme completes.”
Said Norton Rose Fulbright’s Noble: “So long as QE continues, we’ll see a continuation of the same themes that we saw being played out in the first four months of the year. Investors will buy more higher-yielding debt, and we’ll likely see more capital being raised by corporates and emerging market and some eurozone sovereigns.
“Despite the recent bond rout, and despite the topsy-turvy year we’ve had so far, this will remain a great time to be selling euro-denominated bonds, in the short and the medium term.”