In our snap assessment of the ECB's decision yesterday, we highlighted some of the key highlights: the most important part of Draghi's monetary expansion was the inclusion of investment grade non-fin European corporate bonds, a necessary precondition to expanding QE by €20BN due to the scarcity of treasury collateral; the total €1.6 trillion universe of eligible Investment Grade bonds while sizable, is actually far less than it appears on the surface, that there is a "crowding out" danger as traders rush to sub-IG debt which may impair liquidity in the IG bond market next, and that many questions remain unresolved, such as what happens to the debt held by the ECB if it is equitized - does Draghi become an activist investor demand management changes?
One day later, there is more available information, and here courtesy of BofA's Barnaby Martin is an expanded assessment of what the ECB's attempt to explicitly stimulate the European credit really means.
As Martin writes, the ECB has indeed tried to extend a helping hand to the credit market, to help weaken the negative correlation between bund yields and credit spreads (-60% over the last year). As he points out, it was telling that Draghi highlighted issues such as bank bond volatility and senior bank debt maturities today. To BofA this is a sign that the ECB is aware of the deteriorating health of the credit market. Naturally, it believes that the corporate bond purchases will be a bullish tailwind for spreads (although we would expect supply to pick up meaningfully as well).
Here are the highlights from his report:
An “OMT” for credit markets in the short-term…
What of the details of corp purchases? As yet, they are very sparse. The ECB will appoint a committee to investigate the scope of buyable assets. Thus, it feels like the central bank is in the very early stages of thinking about corporate bonds. We know little about the volume of debt they intend to buy (although corps will help the ECB achieve their €80bn per month target under the expanded Asset Purchase Programme).
But with potentially 4 months to wait until corporate bond buying begins, we believe credit spreads will be squeezed tighter amid the uncertainty. In late 2014, covered bond spreads went much tighter after the third covered bond buying programme was announced in early September – even though purchases only began in earnest in November that year (chart 2).
Thus, we think of today’s (light) announcement of corporate purchases as a kind of “OMT” (Outright Monetary Transactions) moment for the credit markets in the shortterm. The pledge by the central bank to intervene carries powerful weight, we think
What was announced?
The ECB announced the creation of a Corporate Sector Purchase Programme (CSPP). What has been announced so far is:
- Euro-denominated, IG, non-bank bonds, from companies established in the Euro area, will be included in the list of assets eligible for regular purchases under the CSPP. Banks will therefore not be eligible, but (senior) insurance debt will be.
- Eligibility under the Eurosystem’s collateral framework will likely be a necessary condition for determining the eligibility of assets to be purchases under the CSPP (although this is subject to further criteria). Scanning the list of ECB eligible assets suggests no subordinated debt will be bought (such as sub insurance, corporate hybrids). However, there seems to be no obvious restriction on the maturity of bonds that are eligible collateral.
- Securities issued by credit institutions, and by entities with a parent company which belongs to a banking group will not be eligible. Auto finance debt is classified as banks within the ECB eligible assets universe so will likely not be purchased (RCI banque, FCE bank PLC, etc)
With these rules, chart 3 shows that a starting Euro IG credit universe of €1.6tr (based on our ER00 index) is quickly whittled down to €554bn when the above restrictions are applied (Euro area corporates only, no sub debt etc.)
From this filtered universe, the charts below show the main sector and country weightings. Thus, corporate bond purchases could be bullish for French and German credits (chart 4) and utilities, transport, energy and basic industrials sectors (chart 5).
What could they buy?
Further technical details on the CSPP will be announced in “due course”. So for now, we know little about how they will approach buying the non-financial part of the credit market that fits the above paramaters. For instance:
Will they buy names on negative watch?
Will they buy low-BBB names with fallen angel risk?
Will a 3rd party fund manager be used to credit select, and avoid the weakening fundamentals in some commodity-linked sectors, for instance?
And what about buying in the primary market, similar to how they are approaching covered bonds?
The winners…and “losers”
With an explicit mention of corporate bonds today by the ECB, we suspect most sectors will rally over the weeks ahead. But the genuine outperformers should be:
- IG non-financial bonds.
- French and German credits, and the utilities, transport, energy and basic industrials sectors (as highlighted above).
- Corporate hybrids appear not to be directly purchasable, but we highlighted the helpful trickle-down effect to corporate hybrid spreads earlier in the week (note a large part of the corporate hybrid universe is utilities).
- Likewise, high-yield – while not eligible to be bought – should rally in sympathy (and improving relative value to IG). Keep an eye on IG/HY spread ratios.
- Bank senior debt should also tighten amid a healthier credit market, but also thanks to the new 4yr TLTROs (targeted long term refinancing operations), unveiled by the ECB today.
The “losers”, will likely be:
- Reverse Yankees (US issuers in Euros) have been the new issuance phenomenon over the last year. These will not be eligible, so should relatively lag. That said, down the line there may be more free-float in these bonds for investors to buy.
- Likewise for all non-Euro Area credits (UK issuers, for instance).
- Sub debt (banks + insurance), although our bank credit team highlighted the favourable comments from the European Commission towards AT1s.
The future is…
No doubt, more about the ECB’s plans for credit will be revealed in the weeks ahead. But if ECB buying is material in size (something we questioned though last week), investors could end up “crowded into” what the ECB isn’t buying (Reverse Yankees, UK issuers, sub debt). This could increase credit market risks for investors (note that Reverse Yankees spreads are clearly more volatile than core credit spreads).
If the ECB actively buys in primary, access to new bonds will be harder for credit investors…
And, if a large, price-insensitive buyer in the corporate bond market (The ECB) has indeed just emerged today, we think credit market liquidity may deteriorate even further…