In April of last year we said the ECB would soon end up buying corporate bonds.
We’re not sure if one year later counts as “soon” or not, but ultimately, we were proven correct when, earlier this month, Mario Draghi announced a new easing “package” that includes IG non-fin EU corporates as part of a plan to increase monthly asset purchases by €20 billion.
While our call may have been prescient given that it came 11 months ago and just one month after the ECB implemented PSPP, by the time this month’s ECB decision rolled around the market generally suspected that Draghi might take the plunge. After all, he massively disappointed in December and if the 5yr-5yr swap is supposed to be the benchmark by which success or failure is judged, well then there’s plenty more room to ease.
Just as there was no reason to believe the ECB would stop at sovereign debt when PSPP was launched last March, there’s no reason to believe Draghi will stop at IG debt going forward. There’s a kind of one-upmanship going on among DM central bankers and with his massive book full of Japanese ETFs not to mention his monetization of the entirety of JGB gross issuance, Kuroda is still the archetype against which all Keynesian craziness is measured. When judged against the BoJ, the ECB probably still has a ways to go before hitting the limits of central banker insanity and so, we think it's entirely possible that Draghi moves into HY next.
But the reasons to believe Draghi will take the plunge into non-IG corporate credit go beyond the “MOAR is always better” line. As BofAML’s Barnaby Martin explains, the EU corporate sector’s penchant for bond buybacks may ultimately force Draghi further down the ratings ladder lest the ECB should end up entangled tender offers or else end up without enough debt to monetize.
* * *
One issue that comes to mind with corporate bond QE is how will the ECB address the burgeoning theme of corporate debt buybacks? As chart 7 shows, European corporates have been pursuing bond buybacks rather than share-buybacks (that latter has proven underwhelming given tax issues and political pressure).
Bond buybacks by non-financials have been rising ever since the fourth quarter of 2012. In the second quarter of last year, €9bn of debt was tendered by non-financials (either outright or before the announcement of a longer-dated new issue).
What’s driven corporates to consider bond buybacks over more reflationary activities such as capex is, in our view, a combination of very high corporate cash levels (chart 9 shows that European corporate cash levels will increase by year-end to almost €450bn) and the zero/negative corporate deposit rates that are emerging across Europe (chart 10).
Rather than corporates suffering what we call “double taxation” (i.e. paying interest on debt obligations and paying interest on cash holdings), it has become more efficient for corporates to buy back their bonds. Added pressure has come from the rating agencies which have been motivating companies to refinance upcoming debt maturities ahead of time (especially when specific bond maturities are large).
We think this raises an important logistical point for ECB QE. If the ECB wants to avoid getting caught up in having to potentially make decisions on corporate tenders, then we think it may focus on buying bonds with maturities of 5yrs and higher.
But if we exclude 1-4yr bonds (chart 11) then this shrinks the ECB eligible universe from €550bn to only €361bn – just 22% of the true European IG credit market size.
If the ECB does not exclude the front-end of the credit market from their buying, then what will they do if corporates continue to tender for their bonds?
- If the ECB agrees to tender, then corporate bond buying could become a moving target for the central bank (their cumulative buying total would be subject to frequent falls).
- But if the ECB does not participate in tenders then they would be hindering the ability of European corporates to efficiently manage their balance sheet in a low interest rate world.
* * *
In other words, if the ECB intends to pull from the eligible pool of €550 billion in purchasable IG credit, they'll have to risk getting themselves involved in tenders which, as BofA puts it, would create a "moving target" for corporate bond purchases. If the ECB buys in the 1-4 year bucket but refuses to participate in tenders, well then companies won't be able to refi to take advantage of lower borrowing costs.
The only way to avoid having to make that decision is to stay away from the front end, but that reduces the universe of QE-eligible corporate bonds to just €361 billion, bringing us full circle to BofA's conclusion: "...[this] potentially means that the ECB might have to consider buying BBs down the line."
And just like that, the central bank dash for trash will be on.