3rd June 2016
Gordon Shannon, portfolio manager at Twentyfour Asset Management, assesses the impact of European Bank quantitative easing on the European bond market.
With June being the point where the primary market traditionally slows down into its summer close, we felt this was a good point to review bond issuance so far this year and what it can tell us about where best to position for the remainder of 2016.
As a result of the rolling bear market we witnessed in the first quarter, primary market activity was very supressed. However, this dynamic changed rapidly as the market began to rally part way through March and we have seen a flood of corporate bond issuance since then. Having more than caught up on the lacklustre start to the year, IG Euro issuance year to date is already up to 81% of last year’s total issuance with seven months left to go.
Having mentioned that this pickup in issuance coincided with the market rally, we can be more specific in attributing its cause: On 10th March, the ECB announced it would be commencing a Corporate Sector Purchase Programme (CSPP)in June – buying Euro-denominated bonds issuance by non-bank European based corporates. The ECB can purchase in the secondary and primary markets, bonds between 6 months and 31 years to maturity with a single Investment Grade rating from any of the rating agencies, taking up to 70% of an issue.
Prudently (given it will struggle to find enough paper to meet its purchase targets) the ECB has cast as wide a net as possible in the bonds it is permitting itself to buy. None-the-less various classes of bonds are still excluded. High yield bonds will not be included, nor investment grade subordinated insurance paper or corporate hybrids, obviously dollar and sterling IG will not be purchased but nor will Euro-denominated paper issued by companies not established in the Euro area such as British Telecom or IBM.
So has this partitioning of the market influenced the behaviour of issuers? Examining monthly subsets of issuance – the answer is certainly. When we filter for the issuance of bonds which would have fit the CSPP eligibility criteria, the growth in issuance after the announcement is much more pronounced. Specially breaking March into pre and post the announcement we see €6.9bn before it and €24.1bn after.
In comparison sterling issuance has remained muted.
Euro High Yield while buoyed from its weak start is low versus its year to date level at end of May 2015.
What are CSPP eligible issuing corporates doing with the money raised from this bonanza of issuance? Aside from Q1 the markets have been wide open to European IG names for the last year so we cannot believe they were in dire need of this funding. One would hope the majority are simply pre-funding their next few years’ requirements and locking in attractive levels. But there will be a temptation to divert some of this cash to shareholders via buybacks and special dividends thus raising leverage. We witnessed plenty of this sort of late-cycle behaviour in the US last year, which preceded a sharp widening of spreads on US names. M&A is another dangerous attraction to companies with an excess of liquidity. So while we hope to see a virtuous circle of lower funding costs and sensible investments from those that benefit from the programme, it is likely that overall leverage will rise. On the one hand the ECB is generating a strong technical to support Euro IG spreads but on the other they could ultimately be weakening the fundamentals of some of these corporates.
Attempting to get long CSPP eligible paper now in the hopes of a further grind tighter, risks an unravelling of its recent performance if the market detects any hint of disappointment in the ECB’s execution of the programme. The current market consensus suggests that the ECB will target the purchase of around €5bn corporate bonds a month (although we have seen some reports mentioning a surprisingly high €10bn.) An aggregate €60bn a year is around 1% of the eligible universe, or put another way 50% of the gross issuance we would have expected into the Euro market or 100% of the net issuance (given over the year bonds will mature and be tendered.) To achieve what the market expects (and what is currently priced into Euro IG spreads) is an aggressive target. It will be tempting as they hit obstacles to slow down or change tack slightly rather than continually roll over the European insurance companies and pension funds, they will be competing with to buy this paper. The ECB has already admitted during discussions with investment bank trader desks (whose cooperation it will desperately need when implementing the purchases) that it will count purchases of commercial paper as part of its CSPP target. A move in this direction will certainly underwhelm the market, particularly those who have frontloaded their buying of corporate bonds on the assumption the ECB will be lifting all of the net supply this year.
Given the recent strong performance of the spreads of CSPP eligible paper we have a preference for bonds just over the border of eligibility. While the technical of ECB buying could well cause further spread tightening, working against this is the change in issuer behaviour which means non-eligible bonds will benefit from a relative lack of supply and less likelihood of a shift to more equity friendly behaviour; the spill-over effects of stronger demand from investors moving beyond their core holdings when seeking acceptable returns and for those issued in sterling or dollars – higher all in yields (this can be clearly seen in a chart below which we update daily as part of our Observatory Datasheet.)
Source: Bloomberg, As at 2nd June 2016
In summary we think it’s better to continue seeking undervalued credits with improving fundamentals in sterling, dollars or high yield euros. It takes more effort to find bonds like this than to assume the ECB’s buying alone will raise prices but it is still possible and allows us to sleep a lot more comfortably.