One cer­tainty in an un­cer­tain world

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

Credit

rat­ings can have a pro­nounced

High-yield bonds are also ben­e­fit­ing.

sig­nif­i­cance.

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.

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