One certainty in an uncertain world
In an uncertain world, in which Brexit, the US presidential elections, the future of the eurozone, are all strewn with wild cards whose potential impact is impossible to quantify, investors are left grasping for certainties. One is that whatever happens in the near term, the European Central Bank will continue to buy financial assets, including corporate debt.
The ECB only began buying investment grade corporate bonds as part of its quantitative easing effort in June, purchasing EUR 8.4 bln in the first month of its programme. However, the effect on financial markets was clear even before its buying started. Since March, when the programme was announced, the average yield on eligible bonds has fallen from 1.45% to almost 0.5%, with spreads contracting sharply towards last year’s lows (see chart). In that sense, the programme has already scored a notable success, given that one of the ECB’s aims was to reverse the widening of corporate spreads which followed its introduction last year of sovereign QE and to restore some stability to corporate borrowing costs relative to benchmark rates. For investors, there are four salient points to consider: Whether the ECB’s programme of corporate QE will succeed in generating growth is hotly debated. Corporate debt issuance was strong in the second quarter, but the effect will depend on how all the cheap financing is used. If it is used to fund capital investments that generate new demand in the real economy, growth will follow. If it merely funds financial engineering, such as stock buybacks to support earnings per share or cost-cutting acquisitions, the effect on growth will be nugatory.
Either way, experience suggests the program will continue
— either because it succeeds, or because if there is no evidence of success, the ECB will double down on its bet.
ratings can have a pronounced
High-yield bonds are also benefiting.
Under the terms of corporate QE, the ECB will buy only investment grade bonds—those rated BBB or better. Since the programme was announced, eligible BBB-rated bonds have outperformed more highly-rated securities. However, if economic growth fails to pick up, it is likely a number of BBB-rated bonds will be downgraded, which would automatically eject them from the ECB’s eligible universe, inflicting heavy losses on holders.
Although the ECB is not buying high-yield debt, the proportion of BB-rated bonds yielding more than 4% has fallen from 43% on January 1 to just 20% today. Despite this move, the asset swap spread for the Merrill Lynch high-yield index is still around 100bp above its 2014 low, implying there is more value to be extracted. Given the shortage of high-yield assets in the eurozone, demand for yield will continue to provide support. However, investors should note that since May, eurozone high-yield asset swap spreads have underperformed their US equivalents, and recall that if the economy deteriorates, subinvestment grade corporates will be more likely to run into trouble and their debt to underperform, especially without direct ECB support.
The ECB repeated last week that it is ready to expand monetary policy even more if needed.
Action could include cutting the deposit rate to -0.50% and widening the pool of assets eligible for corporate QE, possibly to include the senior investment grade debt of banks.
Despite lower funding costs for Europe’s largest companies, heightened political risk will continue to cloud the outlook for equity markets. In this environment, eurozone corporate bonds represent a rare “heads I win, tails I don’t lose” proposition, offering the potential to rally further, plus the backstop provided by the ECB’s determination to place a cap on yields.