Why the ECB Could Get Some Junk With Its Bond-Buying Program
In times of crisis lend freely against good collateral, Walter Bagehot suggested back in 1873. Almost 150 years later, the influential essayist's dictum may prove to be easier said than done for the world's policymakers.
Earlier this month the European Central Bank announced it would begin buying corporate bonds carrying investment-grade ratings in its efforts to further lower the region's borrowing costs. While technical details of the buying program have yet to be announced, the central bank has said that it plans to broadly follow the Eurosystem's existing collateral framework, which requires debt eligible for purchase to carry a minimum credit rating of single A- from a single credit rating agency.
News of the ECB's Corporate Sector Purchase Program (CSPP) unleashed a wave of investment-grade bond issuance as risk premiums on the debt compressed. More interestingly, given that non-investment grade debt would appear to be excluded from the program, the announcement also sparked a deluge of issuance from junk-rated European companies with more fragile balance sheets. Companies with high-yield ratings including Fiat Chrysler Automobiles NV, HeidelbergCement AG, EDP Finance BV, and Faurecia have been selling deals in recent days, with the initial tally of junk-rated issuance jumping to more than €2.5 billion in the week following the ECB announcement, exceeding the €2.3 billion that had been sold in the first two months of 2016.
While junk-rated companies could be taking advantage of a general drop in government and investment-grade corporate borrowing costs bleeding into the high-yield sector, there could be something else taking place. In a note titled "Meet the ECBBs," or BB-rated bonds eligible for the ECB's corporate bond-buying program, Barclays Plc analysts point out:
"To qualify as 'investment grade' for the CSPP programme, the central bank requires an investment grade rating from one agency only as opposed to benchmarks that usually look at the average of all available ratings. This allows for certain high yield issues to be eligible for ECB purchase."
On that basis, Barclays' Tobias Zechbauer and James Martin reckon junk-rated bonds issued by Italian motorway company Autostrada Brescia Verona Vicenza Padova SpA, Spanish phone tower operator Cellnex Telecom SAU, Fresnius SE, Germany's Deutsche Lufthansa AG, fertilizer company K+S AG, and Telecom Italia SpA, could be eligible for ECB buying.
While it remains early days for the CSPP, worries over moral hazard embedded in yet another central bank bond-buying program remain rife.
On that note, while much ink has already been spilled over the potential shape of the ECB's corporate bond-buying program, far less has been devoted to its actual purpose.
While one might broadly infer that central bank buying of bonds sold by companies is aimed at generally reducing corporate borrowing costs and stimulating the wider euro zone economy, there are nuances at play. As highlighted earlier this week by Nathaniel Rosenbaum and George Bory, credit strategists at Wells Fargo & Co., at issue is the degree to which the central bank is attempting to play catch-up with its U.S. counterpart in terms of monetary easing.
Where the Fed focused on a so-called portfolio rebalancing effect, encouraging investors to switch out of government bonds and into riskier assets including stocks and corporate bonds, the ECB is directly focused on boosting the corporate bond asset class itself. It's a page out of the Fed's strategy book, if not a direct copy of its tactics.
Or as Rosenbaum and Bory put it:
"The period marked by successive rounds of Fed QE [quantitative easing] led to a tremendous crowding out of cash and sovereign assets into credit, with 21 months of consecutive inflows to credit between September 2011 and May 2013 for a total of $230 billion of inflows (21 percent increase in assets under management). On the other hand, while the run-up to ECB QE led to 12 months of large inflows, EUR IG [European investment-grade] credit has seen nothing but outflows since sovereign purchases started last spring. Moreover, we’ve seen a noticeable increase in demand for U.S. dollar-denominated credit from European investors hunting for yield, which arguably has sapped demand for EUR IG credit, whereas U.S. investors did not have this same alternative (buying higher yielding EUR credit) during the periods of Fed QE."
Corporate debt purchases by the ECB will certainly help suppress yields and cap corporate borrowing costs, providing a healthy boost to capital expenditure, another measure on which Europe is lagging versus the U.S. Moreover, corporate debt purchases may allow European companies to enjoy a little "financial engineering via buybacks and M&A," as Rosenbaum and Bory put it. Here, too, the euro zone has been lagging behind its trans-Atlantic peer.
"Buybacks marked the first stage of corporate releveraging in the U.S. as they provide management teams a certain degree of flexibility in their execution. While buybacks do not directly create jobs, they do help to sustain the 'wealth effect' and in turn boost consumer confidence. European equities have lagged for well over a year and thus a pickup in buybacks could be helpful in putting a floor under European equities. M&A activity can provide a similar boost to the 'wealth effect' as companies typically pay a premium to acquire their competitors. Thus far, Europe has lagged on both fronts. If the CSPP program is successful, we would expect to see a sharp pickup in both of these activities."
Of course, Bagehot's dictum has been somewhat oversimplified. His urging of central banks to lend against good collateral was more of an encouragement to help businesses that would, but for financial crisis, be solvent and in good health. On that note, the ECB's corporate bond-buying program could yet prove to be a boon for the wider euro zone, though critics of central bank actions are just as likely to argue that it will end up distorting the market rather than saving it.