The challenges of private debt purchases by the ECB
Summary:
– On March 10, 2016, the Governing Council of the European Central Bank (ECB) announced its intention to expand its asset purchase program, which had previously focused on the purchase of sovereign debt (PSPP program), covered bonds (CBPP3 program), and asset-backed securities (ABSPP program) – to private debt (new CSPP program).
The private debt market targeted by the ECB is estimated at around €400 billion, or approximately 25% of the investment grade (IG) credit market in the eurozone. The ECB’s announcement was followed by a rise in the price of investment grade(IG) and high yield(HY) bonds, significant buying ofexchange-traded funds(ETFs) and selling ofcredit default swaps(CDSs) for so-called « synthetic » long positions.
– The lack of liquidity in the private debt market, coupled with the risk of disappointment among operators, particularly if the ECB fails to satisfy the market in terms of the amount of private debt actually purchased over the coming months, could lead to a return of volatility and a rise in rates on the private credit market.
On March 10, 2016, the Governing Council of the European Central Bank (ECB) announced its intention to extend its asset purchase program, which had previously focused on the purchase of sovereign debt (PSPP program), covered bonds (CBPP3 program), and asset-backed securities (ABSPP program) – to private debt (new CSPP program).
1 – The ECB extends its asset purchase program to private debt
As part of the expansion of its asset purchase program, the European Central Bank decided to launch a private debt purchase program called the Corporate Sector Purchase Program (CSPP) at the end of June. This new program will enable the ECB to purchase corporate bonds:
(1) issued by non-financial companies;
(2) whose headquarters are located in the eurozone;
(3) and whose debt is ratedinvestment grade (IG ) by at least one of the three major rating agencies (Moody’s, Standard and Poor’s, Fitch).
This program therefore excludes debt securities issued by financial or similar companies, debt securities issued by companies whose headquarters are not located in the eurozone, as well as convertible bonds and other hybrid securities. The ECB will thus be able to build up a portfolio of eurozone corporate bonds by intervening regularly on the primary and/or secondary markets with the stated aim of further improving financing conditions for the real economy and promoting a return of inflation to a level close to 2%. These purchases will be carried out pending the possible future eligibility ofhigh-yield (HY ) bonds, exchange-traded funds (ETFs) or other equities, similar to what is already being offered by certain central banks (e.g., the BoJ and SNB).
The ECB’s objectives are to inflate the price of financial assets in four ways:
(1) Improving credit conditions for companies in the eurozone to encourage them to invest more, particularly by boosting CAPEX, thereby helping to push inflation back towards the 2% target.
(2) Supporting share buybacks by European companies in order to boost equity markets (increase in share prices) and generate a wealth effect that is favorable to consumption. European companies will thus be encouraged to take on debt in order to redistribute part of this borrowing to shareholders.
(3) Support for the mergers and acquisitions market, which would benefit the banking sector.
(4) Support for investors’ portfolio reallocation towards riskier securities, with the aim of supporting all sectors of the economy, as investors are encouraged to sell their IG debt securities to the ECB in order to turn to riskier, and therefore more profitable, HY debt securities.
The market targeted by the ECB is estimated at €554 billion by Bank of America Merrill Lynch. Excluding bonds nearing maturity, which are unlikely to be of interest to the ECB, the private debt market targeted by the ECB is estimated at around €400 billion, or approximately 25% of the IG credit market in the eurozone.
Large French companies (€360 billion in IG private debt) and German companies (€300 billion in IG private debt), and to a lesser extent large Italian companies (€120 billion in IG private debt) and Spanish companies (€105 billion in IG private debt), should benefit from this private debt purchase program, which should have a favorable effect on credit conditions in the core of the eurozone, but also in the periphery.
2 – Investor reactions on the corporate bond market
On the IG secondary market, the ECB’s announcement was followed by a rush of traders to corporate bonds potentially targeted by the ECB (the program remains to be defined in more detail), leading to a fall in rates (and a rise in prices) across all eurozone corporate bonds.
On the IG primary market, the ECB’s announcement was followed by a rush of companies to the primary market, which took advantage of renewed investor enthusiasm to issue a record level of debt. These companies benefited both from a widespread fall in risk premiums across the private market and the emergence of a buyer of last resort (the ECB) to raise massive amounts of funds on this market.
Historic issues were observed in the IG segment. The brewing group Anheuser-Busch InBev successfully raised €13.25 billion (a new record in the eurozone), while other auctions were oversubscribed with a coupon close to zero, as was the case for the private debt offered by the pharmaceutical company Sanofi (a record rate for a non-financial company with a rate of 0.05% for three-year bonds). These facts lead us to consider the possibility of negative rates on the primary market, similar to certain yields on the secondary market (Royal Dutch Shell, Roche, Sanofi, Air Liquide, and Siemens, for example).
In the high-yield (HY) primary market, lower-rated companies have also taken advantage of renewed enthusiasm among credit market operators to become active in the primary market, as the ECB requires only a single investment grade rating for a private debt security to be eligible for repurchase, effectively qualifying certain bonds on the borderline between IG and HY, while shifting part of the demand from the investment grade category to the high yield category.
3 – ETFs and CDS used by operators to play the ECB put
Investors have positioned themselves using exchange-traded funds (ETFs) on the buy side and credit default swaps (CDS) on the sell side. Insured against the upcoming decline in the price of corporate bonds in the eurozone, they were motivated by the possibility of reselling them at a better price to the ECB in the coming months. These two instruments are often used to intervene in the credit market because of their high liquidity (as opposed to a much less liquid credit market).
The ECB’s put via CDS. The sale of credit default swaps, combined with the purchase of risk-free debt (sovereign debt), is thus used by some operators to build up so-called « synthetic » long positions. The seller of credit event derivatives receives both the CDS risk premium and the risk-free rate, which is a way for them to be exposed to credit risk in the « purest » form (lower liquidity premium for CDSs compared to bonds, making CDSs the benchmark instrument for those who wish to be exposed to credit risk). The ECB’s announcement thus led to a significant drop in CDS prices (and an increase in CDS sales), with some operators taking short positions in anticipation of a decline in the default risk on the debt securities targeted by the ECB.
The ECB put by ETFs. The capitalization of investment-grade index funds thus became greater than the market value of the underlying assets replicated by these same index funds (liquidity premium). The ECB’s announcement thus led to a sharp increase in assets under management in index funds dedicated to IG and HY bonds (€6 billion in new assets under management in European bond ETFs since the ECB’s announcement, for a market capitalization of approximately €460 billion for IG bond ETFs in the eurozone).
4 – Two significant risks
High volatility in the corporate bond market. Repeatedpurchases by the ECB starting this summer, in a relatively illiquid market, could lead to a sharp drying up of liquidity with sharp price increases (and sharp rate declines) on the most illiquid securities. Conversely, if the ECB fails to acquire a sufficient level of private debt by the fall, prices could reverse (accompanied by a rise in rates).
The sharp contraction in risk premiums, encouraged by the unconventional and ultra-accommodative monetary policies of central banks, automatically reduces the cost of financing potentially risky projects to an unreasonable extent, thereby favoring unprofitable investments and poor capital allocation, which has a negative impact on potential growth. Many companies could thus be encouraged to focus on their own valuation (share buybacks or dividends) at the expense of longer-term investments, while others could be encouraged to invest in risky and counterproductive projects (generating excess risk relative to potential returns).
Conclusion
By offering the market further support through its private debt purchase program, the ECB is continuing its policy of crushing spreads and thus eliminating risk premiums in the eurozone, encouraging investors to turn to ever riskier assets.
Although this program appears to be beneficial to the credit market in the short term, the ECB’s highly expansionary policy could prove counterproductive in the longer term, due to the distortions it generates both in terms of asset prices (relative to the fundamental value of those assets) and wealth gaps in the eurozone (between those who own assets and those who do not), ultimately preventing any rise in interest rates.
References
– ECB press release, March 10, 2016
– Bakewell Sally, “AB InBev Sets Euro-Bond Sale Record to Fund SABMiller Takeover,” Bloomberg, March 16, 2016
– Linsell Katie, “Sanofi Finds Money Almost Free in Draghi-Fueled Euro Bond Market,” Bloomberg, March 29, 2016
