James Bevan: bond purchases and central banks
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James Bevan
Among the world’s major central banks, the Fed’s officials seem to talk in public much more often than do their counterparts in the European Central Bank, Bank of Japan, Bank of England, and People’ Bank of China.
With the US being the world’s largest economy, Fed policy decisions have typically reverberated most around the world.
But the ECB and the BoJ have increasingly re-written the rules of central bank engagement with “unconventional” policies.
The ECB implemented negative interest-rate policy (NIRP) on 5th June 2014 and the BoJ did the same on 29th January this year. And now we have the ECB set to purchase corporate bonds from June and the BoJ reportedly ready to offer negative interest-rate loans (NIRLs).
Purchase expansion
The bullish consequences of ECB purchases of corporate bonds could be much more significant for both bonds and stocks than widely recognised.
In his prepared remarks and Q&A session after the formal ECB releases, bank president Mario Draghi glossed over the latest details of the corporate sector purchase program (CSPP).
It was first introduced after the 10th March meeting of the ECB’s governing council, and is scheduled to start in June.
The details of what’s now planned are important with the scope of buying to be significantly broader than implied by the March press release that introduced the programme.
Thus the ECB’s overall bond-buying programme was expanded from €60bn to €80bn per month on 10th March, and separately, corporate bonds were added to the list of monthly eligible purchases, although the monthly purchase amount of such bonds wasn’t specified.
Two significant new details about the CSPP were provided in the ECB’s latest press release: the type of eligible bonds was increased and the share limit per issue was specified. The volume of CSPP holdings will be published on a weekly and monthly basis. A breakdown of primary and secondary market purchases will also be published every month.
The original press release specified that investment-grade euro-denominated bonds issued by non-bank corporations established in Euroland would be included in the list of eligible purchases.
Language was added to the second press release to include “corporations incorporated in the euro area whose ultimate parent is not based in the euro area,” assuming they meet all other criteria.
In addition, the ECB decided to apply an issue share limit of 70% per security of the outstanding amount.
That seems like a big slice of each pie. Nevertheless, Mr Draghi said during his
ECB president Mario Draghi
press conference that he doesn’t see a scarcity issue when it comes to the ECB’s bond-buying programme.
Scarcity
So, why does the ECB need to take its bond-buying program so far if there isn’t a scarcity issue?
No wonder German pension fund and insurance company managers are angry. They’ll have to compete with the ECB to get puny returns on a smaller supply of bonds.
The ECB’s Q&A section accompanying the press release posed the question: “Will the Eurosystem apply any measures to mitigate potential negative effects on secondary market liquidity?”
The ECB’s answer: “When implementing the CSPP, the Eurosystem will be mindful of the potential impact of its purchases on market liquidity … Similarly, when buying in the secondary market, it will consider … the scarcity of specific debt instruments and general market conditions.”
The volume of corporate bond purchases wasn’t specified – so let’s just assume that the ECB buys €20bn per month on average. That would add up to €200bn over the course of the remaining 10 months of the overall bond-buying programme.
Relative to the €900bn in euro-denominated non-financial corporate debt outstanding, the ECB would own almost 25% of the market. That’s assuming that the programme lasts its minimum prescribed length from June 2016 to March 2017, although Mr Draghi said it could be extended.
Projecting the ECB’s share gets trickier when considering that credit quality will reduce the number of eligible securities, as will maturity rules and a few other constraints.
Furthermore, the ECB may also purchase non-bank financial issues including the bonds of insurance companies and bank subsidiaries of non-bank parents.
Total outstanding debt of financial corporations other than monetary financial institutions stood at about €2.4tn as of February. Accounting for this larger market, the ECB’s bond-buying would be just shy of 10% of outstanding securities, leaving the ECB’s potential market share likely between 10% and 25%.
Either way, it’s big. The total amount of corporate bonds purchased will depend on the actual monthly purchases (which could be more or less than €20bn) and the ultimate time horizon if the programme is extended beyond 10 months.
Buy backs
Apart from the benefit for Euroland’s stock market, non-Euroland companies can benefit via Euroland subsidiaries – so companies such as Caterpillar and GE Capital, both of which have European bond issuers based in Ireland. Others companies can set up new subsidiaries and secure credit ratings before issuing.
If the ECB does spend money on ‘US’ debt, that cash may end up in the hands of shareholders given the buyback craze.
But even if the ECB doesn’t buy enough ‘US’ debt to affect the US stock market, pension funds and other long-term institutional investors around the world may be forced to buy more corporate bonds in the US with the ECB reducing both the available supply and the yields of corporate bonds in Euroland.
That obviously would be bullish for stocks around the world, especially in the US, where low bond yields likely would stimulate yet more buybacks and M&A.
The CSPP explainer did add: “As on any diversified portfolio of credit instruments, risks from the deterioration of issuers’ credit quality or from defaults of issuers cannot be totally excluded.”
This reflected the eligibility rules which state that purchased issuances need only have a minimum credit quality of rating BBB – or the equivalent from one approved external ratings agency.
That level of quality is just one downgrade away from being non-investment grade and not only might the ECB end up with junk on its balance sheet, it may have no choice but to buy some speculative issues to meet the asset purchase programmes’ buying objectives.
As a technical aside, the debt securities data mentioned above can be found within the ECB’s table of “Outstanding amounts and transactions of euro-denominated debt securities by country of residence, sector of the issuer and original maturity: February 2016.”
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
Mario Draghi photo: ECB
