Two weeks ago, as part of our continuing coverage of the Steinhoff fiasco in which it emerged that the ECB was the mystery and (not so) proud buyer of just issued Steinhoff (now junk) bonds (maturing in 2025 but set for bankruptcy within months) and which lost more than half of their value overnight when it the company announced it was caught in what may be a terminal accounting fraud scandal, we said that ", it seems virtually guaranteed that the banks will suffer steep haircuts on their Steinhoff exposure" and "so will the ECB, which on Friday was rumored it was considering selling its Steinhoff bonds. It is not exactly clear how this would take place, since the ECB's QE by definition only buys, not sells, at least for now."
This just barely perceptive shift in the ECB's posture from "buyer of first, last and only resort" to "potential seller", has potentially huge implications, and was duly noted by one of the best credit strategists on Wall Street, BofA's Barnaby Martin, who in a note over the weekend look at the "gift that keeps on giving", or at least "kept on giving", and adds to our speculation, writing that "one consistent feature of the last year and a half has been the ECB buying copious amounts of corporate bonds week-in, week out. Such has been the need to promptly restore inflation in the Eurozone – to ensure the debt sustainability of the periphery – that unique monetary policy has been the order of the day. No other central bank has dived headlong into buying corporate bonds. And given the slow return to 2% inflation in Europe, as confirmed by the ECB yesterday, for 2018 we again expect Draghi to be pronounced in buying credit, pushing spreads even tighter."
We showed the ECB's unprecedented impact on the bond market this July, when we charted the collapse in Eurozone credit spreads following the announcement of the ECB's CSPP, or corporate bond buying program.
And while until just two weeks ago, Draghi's dedication to purchasing virtually any and every piece of (non-junk) corporate paper in Europe was undisputed, "2017 is ending on somewhat of a sour note, in the form of rising idiosyncratic risk…the most distinctive of which has resulted from the Steinhoff bonds."
While Martin doesn’t see the Steinhoff fiasco as derailing the ECB’s drive to purchase corporate debt next year, "we do see a risk that the CSPP becomes more cautious. The risk, therefore, is that the ECB’s efforts to compress credit spreads is reduced. And if they start to buy more higher quality names then this would weaken the compression trade in corporate bonds next year."
And while one can speculate about Drahig's intentions, it looks like the ECB’s language towards owning Fallen Angels has become more explicit, and more tentative of late. This is a major risk for what until recently was one of the best performing bond categories - those which have been recently downgraded from IG to junk, i.e. fallen angels - because, "If true, we think that this has the potential to make the spreads of Fallen Angels behave more like Falling Knives. Credit investors should therefore anticipate more pronounced price drops in names that migrate from IG to HY" the BofA strategist warns.
Putting the Steinhoff Debacle in Context
As we have repeatedly written here in the past year, there has been no bigger buyer of European corporate credit in the past two years than the European Central Bank: the ECB, which currently owns just over €131 billion of European corporate bonds, or 17.9% of the total outstanding amount, is likely to finish 2017 having bought just over €80bn of Euro-denominated corporate bonds in 2017 alone. According to BofA, such is the quantum of monthly QE buying relative to net supply, that CSPP creates an obvious “scarcity of product”, causing credit spreads to keep grinding tighter. As Chart 1 highlights, Euro high-grade spreads have widened in only 5 of the last 19 months (and have only widened in 2 months of this year).
Further, as shown in Chart 2, the share of SMEs reporting higher turnover increased significantly from April to September 2017 as the ECB program continued compressing spreads to record tights. The move is especially visible in Italian SMEs’ turnover. According to BofA, this provides further encouragement for the ECB, as the latest survey on Access to Finance for Enterprises shows that Euro Area SMEs reported increasing profits for the first time since the beginning of the survey in 2009.
That was then, this is now
Until two weeks ago, and the revelation that the ECB is a deep holder of an unknown amount of Steinhoff bonds, the confidence autopilot was solidly engaged, and it seemed like there is nothing on the horizon that could deter the ECB from being the corporate bond buyer of last resort. That's when Steinoff hit, and as discussed here first, the 2025 bonds fell from 83 to 39 since the end of November on the back of the CEO resigning due to suspected accounting irregularities.
Latest ECB disclosure shows that the ECB own some of the recently issued Steinhoff Europe AG bond – an €800m 2025 issue. Note that Steinhoff International Holding’s headquarters are in South Africa, yet the recent Euro bond was issued out of an Austrian entity, ensuring CSPP eligibility.
Here there was some good, and some bad news for buyers and holders of junk bonds.
During last week's ECB press conference, Draghi said that the ECB's losses with respect to the Steinhoff holdings were a lot less than consensus has been suggesting, although he did not divulge an actual number (in light of Draghi's previous lies, one should apply a giant grain of salt to anything the ECB claims is or isn't the case). The history of CSPP new issue “allocations” suggests an average of 11%, but we do not know what the facts are here, and the ECB refuses to provide them.
Whatever the real loss and exposure, in Chart 4 Martin shows that the mark-to-market drop on the Steinhoff bond is far greater than anything else the ECB has realised on their CSPP portfolio to date.
To be sure, Draghi downplayed the Steinhoff debacle, arguing in last week's ECB meeting that the Steinhoff loss is very small in the grand scheme of things to the ECB’s CSPP portfolio, of which roughly 90% of the CSPP portfolio has tightened since purchase (green line in Chart 4).
And yet - and this is the punchline - this event risk which we flagged back all the way in March 2016 when we said that "It is unclear what happens to those IG bonds that the ECB has purchased if and when they get downgraded to junk", will be a notable talking point for the Governing Council according to the BofA strategist, who writes that "If, going forward, it reduces the ECB’s efforts to buy lower quality credit and compress spreads, then we see a risk that the compression trade in credit is less powerful in 2018."
Things Are Already Changing
Indeed, as BofA observes, there are some small signs already of the ECB stepping back slightly from their blanket approach to credit buying, and addressing the question we first asked almost two years ago. In particular, Draghi seems to be taking a more defensive stance with regards to owning Fallen Angels. Note that the CSPP Q&A has been updated as of 29th November 2017, and the paragraph on ECB selling now reads as follows:
Q1.5 Will the Eurosystem sell its holdings of bonds if they lose eligibility?
The Eurosystem may choose to, but is not required to sell its holdings in the event of a loss of eligibility, e.g. in case of a downgrade below the credit quality rating requirement.
Previously this phrasing was far more specific, with forced selling (or otherwise) not even presented as an option:
Q8 Will the Eurosystem sell its holdings of bonds if they lose eligibility? For example, if they are downgraded and lose investment grade status?
The Eurosystem is not required to sell its holdings in the event of a downgrade below the credit quality rating requirement for eligibility.
And, as far as BofA can see, the ECB still owns 3 K+S bonds, which now have a BB S&P rating (the only agency to rate them) following a downgrade to high-yield last October. What can’t be determined, however - despite Draghi's assurances of the ECB's "unprecedented operational transparency" - is whether the ECB have been reducing their holdings of these bonds over time.
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Which brings us to the biggest risk as identified by Bank of America's credit strategist: what until two weeks ago was merely a fallen angel is now a falling knife. Here's why:
With the ECB’s language towards owning Fallen Angels having become more tentative of late, we think that this has the potential to make the spreads of Fallen Angels behave more like Falling Knives in 2018.
Even though the European economy is enjoying a robust cyclical recovery, downgrade risk is still an issue for investment grade fund managers at present. Chart 5 shows that, by par amount, IG downgrades continue to outpace upgrades, and the ratio has actually deteriorated this year. Moreover, Chart 6 shows that credit markets globally have been experiencing negative ratings migration of late. In fact, BBBs now make up almost 50% of Euro, US and Japanese investment-grade markets.
According to Martin, this likely means that the ECB will take a growing interest in Fallen Angels.
So how much of a problem will this be for Draghi? Using S&P’s historical rating transition matrices, BofA estimates that €7bn of corporate bonds that the ECB own will end up as Fallen Angels prior to maturity (by bonds impacted, this is equivalent to €38bn of total outstanding debt). Chart 8 shows that over the last decade, the price drop severity of Fallen Angels has been declining. But if the ECB become a motivated seller of downgraded credits, we feel this dynamic could reverse.
In conclusion, and in Bank of America's explicit warning, credit investors should therefore anticipate more pronounced price drops in names that migrate from IG to HY next year.
"After all, there may now be a big buyer (ECB) behind some of these credits that chooses to become a seller upon downgrade."
The silver lining - if only for deep junk investors - is that Falling Knives could produce a source of technically cheap BBs for yield-starved investors to mull over...