Almost exactly one year ago, we wrote "Mario Draghi, Collateral Scarcity, And Why The ECB Will Soon Buy Corporate Bonds." 11 months later, the ECB confirmed this when for the first time ever, Mario Draghi said he would do purchase corporate bonds when he launched the ECB's Corporate Sector Purchase Programme (CSPP), confirming that with government bond collateral evaporating and the liquidity situation getting precariously dangerous and forcing moments of historic volatility (as in the April/May 2015 Bund fiasco), he had run out of other options.
And while we have been covering this key development closely since its announcement more than a month ago, we were surprised by how little attention most of the sellside was paying to what is clearly a watershed moment in capital markets as a central banks now openly backstops corporate bond issuance (among other things pointing out a month ago Why The ECB Will Be Forced To Buy Junk Bonds Next). Ironically, the market was fully aware of what the ECB's action meant as we showed in the "The ECB Effect: European Telecom Issues Largest Ever Junk Bond After More Than 100% Upsizing."
Now, following the release of the full details of its corporate bond buying program, analysts are once again keenly focused on hits program who impact will be dramatic over the coming years.
First, as a reminder, here are the big picture details:
- May buy in primary and secondary markets
- Issue share limit of 70% per ISIN
- Inclusion of bonds issued by insurance companies
- Can buy bonds of companies incorporated in the euro area whose ultimate parent is not based in the euro area
- Remaining maturity of 6 months and maximum of 30Y
What does this mean? Deutsche Bank did a quick run through of the details:
As a quick summary assuming most have seen the details, some of the interesting or most notable points were as follows: The inclusion of non-bank financial institutions; The Eurosystem collateral framework as a basis for determining the eligibility (Non euro-area parent company bonds could be included); The Bank will be active in both the primary and secondary market; Minimum rating of BBB-; Maturity between 6 months and 30 years; Issue share limit size of 70%. It was also confirmed that the purchases will not be conducted by a third party and rather by six national central banks and are due to commence in June.
So what are our thoughts? Well overall the technical parameters of the programme have exceeded our expectations in terms of the resulting size of the eligible universe. In particular this includes the criteria around incorporation, minimum rating, maturity and lack of minimum size of bond issue. As a result, the ECB should be able to do more than we previously expected, provided it is willing to. Our reading of the announcement is that they will at least try to make the CSPP a meaningful part of the extra €20bn of monthly QE purchases announced at their March meeting. We now estimate the size of the eligible universe to be about €770bn based on amount outstanding, and €865bn by market value. These amounts are 50% larger than we expected and we now estimate monthly purchases to be to the tune of about €5bn. While we appreciate that this positive announcement signals the ECB means business when it comes to corporate bond purchases, it still remains to be seen to what extent challenging liquidity conditions in the corporate bond market allow it to buy in size. We think the ECB will try to put a lot of emphasis on primary market purchases and rely on some “supply response” from eligible issuers.
Focus on the "liquidity conditions" part as that is where the next surprise to the market will emerge when there is another exogenous shock to valuations.
Or perhaps not, because as DB's Barnaby Martin writes in a note overnight, "amid the [ECB's] potential hubris, perhaps there has never been a greater need for credit investors to be alert to the divergence of spreads and fundamentals. For instance, Glencore and Shell bonds would appear to be eligible for the ECB to buy. But if commodity prices sour again, will spreads for these names move wider? Moreover with the inclusion of UK headquartered names on the ECB eligible list, can potential Brexit concerns ever adequately be priced into Sterling credit spreads before the Referendum?"
More to the point, Martin who notes that the ECB's CSPP "is bullish for high-grade and also high-yield (via BBs), and expect secondary cash spreads to tighten more meaningfully in June once ECB buying starts (just as issuance is likely to have cooled down)" asks the simple question "Will the ECB QE the world"?
His answer is a tongue in cheek yes.
The reason, the ECB left a very calculated loophole in its buying parameters which allows the ECB to buy the corporate bonds of virtually any global corporation as long as it has an SPV incorporated in Europe!
We think the scope of ECB corporate bond buying could potentially be much greater than we had initially anticipated in March. The ECB stands ready to buy bonds from Euro Area issuers even when their parent companies are outside of the bloc. Already we can find a number of US, UK and Swiss headquartered names that issue out of SPVs incorporated in the Euro Area. If this trend to SPV issuance catches on, then the ECB’s policies will likely be very reflationary for all credit markets across the globe, and because of a likely refinancing wave – equity markets too.
Before we get into the specifics, here is his detailed breakdown of the CSPP and its immediate implictions.
- The Eurosystem’s collateral framework will be the basis for determining CSPP eligibility. The list is updated daily on the ECBs website (and each National Central Bank contributes). This will be the ultimate decider of whether a bond is “in” or “out”.
- The Eurosystem will purchase IG, Euro-denominated bonds issued by non-bank corporations, established in the Euro Area.
- Six Eurosystem NCBs will carry out purchases (Belgium, Germany, Spain, France, Italy and Finland. Note no Netherlands). While the ECB will coordinate the purchases, each NCB will be responsible for purchases from a particular part of the Euro Area.
- For an IG rating, a bond must have a minimum first-best credit assessment of at least BBB- obtained from an external rating agency. This confirms our expectation that the ECB will partially be buying the high-yield credit market.
- Purchases will take place in both primary and secondary markets.
- Bonds with a minimum remaining maturity of 6m and a maximum remaining maturity of 30yr (at purchase time) will be eligible (in line with PSPP methodology).
- Bonds where the issuer is a corporation established in the Euro Area, defined as the location of incorporation of the issuer, will be eligible. Importantly, bonds issued by corporations incorporated in the Euro Area whose ultimate parent is not based in the Euro Area are also eligible.
- Bonds issued by a credit institution (or where the parent is a credit institution) will not be eligible. Neither will bonds issued by a Resolution Vehicle created to facilitate financial sector restructuring (such as the FROB for instance).
- A 70% issue share limit will be applied to securities. This is much larger than we were expecting (but is actually a similar amount to covered bonds).
- Senior insurance bonds are eligible, where the insurer is not defined as a credit institution and does not have a parent that is a credit institution.
- Auto bank bonds will be eligible when the parent company is not a bank (which is the case for RCI Banque and VW bank bonds). Other auto finance bonds (leasing bonds etc.) appear eligible as the ECB does not classify them as credit institutions.
- There is no minimum issuance volume for eligible debt instruments.
- Negative yielding corporate debt is eligible (as long as the yield is more than the deposit rate).
- There will be weekly and monthly publishing of CSPP volumes, and holdings will be made available for securities lending by the relevant national central banks.
- Buying will partly reflect a benchmark. The benchmark will be based on the facevalue weighted amounts of debt that are eligible under the above paramaters.
And here is why the hedge fund known as the European Central Bank has just unleashed what BofA dubs QE for the world:
In our view, the most powerful conclusion from the above is that the ECB could likely end up buying corporate bonds from all over the world. The relevant paragraph is:
Debt instruments will be eligible for purchase, provided….the issuer is a corporation established in the euro area, defined as the location of incorporation of the issuer. Corporate debt instruments issued by corporations incorporated in the euro area whose ultimate parent is not based in the euro area are also eligible for purchase under the CSPP, provided they fulfil all the other eligibility criteria;
And in the FAQ:
Issuers incorporated in the euro area will be eligible for CSPP purchases. In practical terms, this means that issuers must be euro area residents, as in the list of marketable assets eligible as collateral for Eurosystem liquidity-providing operations. The location of incorporation of the issuer’s ultimate parent is not taken into consideration in this eligibility criterion. Thus, corporate debt instruments issued by corporations incorporated in the euro area but whose ultimate parent is not established in the euro area are eligible for purchase under the CSPP, provided they fulfil all other eligibility criteria.
Looking at the “ISSUER_RESIDENCE” column of the ECB eligible assets spreadsheet, we see a list of bonds that are classified as Euro Area resident because the issuance vehicle is an SPV (while the GUARANTOR_RESIDENCE is a non-Eurozone country). Table 1 lists these names. They are a mixture of US, Swiss and UK companies (based on the domicile in our corporate bond indices) but the ECB clearly views them as having Euro Area domicile because the issuing entity is a Dutch or Irish SPV.
Note that Glencore Finance bonds should be eligible to buy, as will Shell bonds.
The conclusion from this is twofold, in our view:
Firstly, the credit market could (worryingly) become much less sensitive to fundamentals such as commodity prices. For instance, if commodity prices fall, debt spreads of Glencore could still tighten if the ECB remains an active buyer of their bonds.
Secondly, there is clear motivation for non Euro-Area companies to issue Euro debt via a Euro-Area incorporated SPV. Our understanding is that the process (and time needed) to set up such a vehicle is not too cumbersome.
If this is the way that the credit market in Euros develops, then the ECB could potentially be “corporate QE’ing the world”. All credit markets stand to benefit in such a scenario as the trickle-down effect looks significant to us.
Yet, investors will need to keep an even closer eye on the likelihood that credit spreads disconnect from fundamentals. For instance, if the ECB buys UK credits then this will exacerbate the lack of Brexit premium in the £ credit market.
And once again, here is why U.S. companies will soon be rushing to create European SPVs to take advantage of the ECB's geneorosity:
We believe the scope of the CSPP could potentially be much larger than we had initially thought in March. Bonds of Euro Area issuers whose ultimate parent company is outside the Euro Area will also be eligible. This could mean that the ECB buys bonds from US, UK and Swiss headquartered issuers, for example, simply because they fund via Euro Area SPVs. The ramification of this is that the ECB will be helping to reflate the global credit market.
But the cherry on top is that this is ultimately a brilliant plan to also keep the Euro weaker:
If more US issuers flock to the Euro credit market for funding, then
converting the money back into US Dollars would helpfully (for the ECB)
keep the Euro weak.
Our question: how long until we see a surge of US-based near insolvent shale companies rushing to incorporate SPVs in the Netherlands or Ireland, just to get the green light to be included in the ECB's asset purchases. We are confident that within 2-3 months of this post, we will see at least one deeply distressed US oil and gas producer suddenly announcing that henceforth its ultimate parent is a post box located somewhere in Dublin...
As for the biggest implications, they are truly troubling: the disconnect between fundamentals and prices will hit never before seen levels, pushing not only equity but corporate bond prices dramatically higher, and as in the case of European sovereign bonds, prevent any true price discovery no matter how deplorable the underlying economic situation is. It also will confirm what most know: that price discovery no longer exists, that markets are merely policy vehicles, and that central banks will be more intertwined in capital markets than ever before, meaning that any attempt at renormalization will be doomed to fail as pricing in the elimination of the expanded global "Draghi put" will lead to a collapse of all asset prices, not just equities but also corporate bonds.