Greg Venizelos, strategist within the research & investment strategy team of AXA Investment Managers, gives his views on the ECB’s Corporate Securities Purchase Program.
On 10 March the ECB delivered a well-targeted stimulus package, addressing some of the key risks that have dogged global markets in the past twelve months: (i) excessive dollar strength, which undermines global risk appetite; (ii) deep negative rates, which undermine bank earnings; and (iii) inability of its ‘sovereign’ QE to support euro credit spreads during its first year of operation.
Through the Corporate Securities Purchase Program (CSPP), the ECB has given itself the option to address the potential scarcity of issues in the sovereign debt space given the higher monthly amount and the means to suppress risk premia if euro credit comes under pressure.
Overall, the measures announced by the ECB are very supportive for credit, both non-financials and financials, including banks.
Positive for euro non-financials.
The prospect of direct purchases of non-financial credit should cap euro IG spreads and spread volatility during market corrections.
Signalling is a key element of CSPP; the program may not even need to purchase that much credit to exert downward pressure on credit spreads.
The ECB as a ‘buyer of last resort’ should in effect become a market liquidity backstop, encouraging investors to participate and absorb euro IG supply (oversupply proved a bugbear for credit last spring).
Portfolio rebalancing effects should prove a strong driver for euro high yield (HY) credit spreads to tighten, as investors rotate into higher-yielding credits. In fact, if CSPP purchases include split-rated bonds, the benefit to BB spreads will be even more direct than just spillover effects.
Eligibility criteria.
The technical details of CSPP remain sketchy, but it is reasonable to assume that the program the bank will buy euro senior debt: of non-financial corporates and non-bank financials; by entities established in the euro zone; rated investment grade (IG); either fixed or floating-rate notes; in sizes proportional to the composition of euro credit benchmarks; perhaps without maturity restrictions, but above a minimum issue size.
If the entity is a subsidiary, it should carry a standalone IG rating exclusive of any guarantees from a non-euro zone parent.
Credit rating thresholds will be a key element. The eligible pool will be larger if the CSPP is allowed to purchase 5B, 7B or 8B credits (5B, for example, is a credit with one BBB and one BB rating) but will carry higher fallen-angel risk.
Lack of maturity restrictions (at the short end) also enlarges the eligible pool, but may elicit complications due to bond buy-back and bond calls.
Pool size/purchase rate.
The Bank of America Merrill Lynch (BAML) index for euro IG non financials has a face value of just under €1tn. Of that c.€600bn is issued by euro zone entities and ~€550bn comprises bonds above €500mn (benchmark size). Adding FRNs, removing maturity limits (ie incl paper <1y), and considering a more lenient rating threshold of ‘best’ rather than ‘average’ rating, could raise the pool to above €700bn.
On the assumption that CSPP buys up to 50% per issue (CBPP3 precedent) we get a size of €350bn, or c.three years’ worth of purchases at a rate of €120bn per annum (€10bn pcm).
That said, while €10bn pcm is comparable to the rate of purchases under CBPP3, we think that the purchase rate under CSPP could be lower, around the €5bn pcm mark, to avoid ‘crowding out’ investors.
In fact, one may envisage that the purchase rate varies between the €5bn mark (in good times, to prevent crowding out) and the €10bn+ mark (in bad times, to prevent excessive spread volatility). For context, annual euro IG non-financial gross issuance is typically €200-250bn; net issuance €80-120bn; monthly traded volume in euro IG non-financials €25-35bn and weekly euro IG retail fund flows €0.3-0.4bn.
Like CBPP, it is reasonable to assume that CSPP will be involved in both the secondary and primary markets. The latter could become a problem for investors, in as much CSPP suppresses new issue spread premia in CSPP-eligible credits.
Spread impact.
We expect the spreads of CSPP-eligible non-financial credits to decline by as much as 40% from their pre-ECB levels (9 March market close). This is comparable to the spread tightening in CBPP3-eligible euro covered bonds between the announcement of that program in September 2014 and the spread lows in May 2015.
Euro IG spreads had exhibited comparable degrees of tightening following earlier ECB interventions, as were the Long-Term Refinancing Operations (LTROs) in December 2011 or the Outright Monetary Transaction (OMT) in September 2012.
In sympathy to eligible credits we pencil in a tightening by 25% for non-eligible euro IG credits. The 60/40 split between eligible and noneligible credits within euro IG non-financials, implies a combined spread tightening of 33% for the index.
Similarly, the 60/40 split between non-financials and financials within euro IG, implies a combined spread tightening of 30% for the index. We have already observed such a dynamic since CSPP was announced on 10 March, with euro IG non-fin spreads 14% lower since 9 March, while euro IG financial spreads are only 8% lower.
An alternative approach for estimating the spread impact could be based on risk/reward. We start from the fact that the CBPP3 program reduced euro covered spread volatility by 10bps. A comparable impact by CSPP on euro IG spread could reduce spread volatility by 15bps (after adjusting for spread beta), or one third of the current volatility level of 45bps.
In such a scenario, an investor who is indifferent in terms of ‘spread to volatility’ ratio (a Sharpe ratio of sorts) would tolerate a spread tightening of one third, since it would leave the sharpe ratio unaffected.
Notably, there is a perfect pecking order in the rally, with euro spreads tighter than sterling spreads, sterling spreads tighter than dollar spreads and IG spreads tighter than HY.
Positive for euro banks.
Beyond the CSPP, further measures announced by the ECB should prove supportive for bank risk premia. The governing council has mothballed the option of deep-negative deposit rates and this offers a relief to bank interest margins, a key factor behind the severe correction in bank stocks earlier this year.
The latest round of repo facilities (TLTRO2) provides funding certainty to banks and should tighten senior spreads through lower (non-TLAC) issuance needs. This should also lower the borrowing costs on TLAC-compulsory senior issuance.
The ‘lend to earn’ approach of a TLTRO2 with potentially negative borrowing rate should encourage lending volumes and thus aid earnings (all things being equal). The trickle-through from tighter non-financial spreads should lower bank debt spreads more broadly.
Lastly, on the morning of the ECB meeting a separate clarification regarding (less) ‘automaticity’ in Maximum Distributable Amount restrictions for Additional Tier 1 (AT1) coupons has helped underpin AT1 paper and bank capital in general.
