“If you have a bazooka in your pocket and people know it, you probably won’t have to take it out.” Henry Paulson, US Treasury Secretary, 2006-2009
It will take some time before the smoke clears from the ECB’s recently fired bazooka in the European corporate bond market. But even though it is unclear how effective the policy will be, we believe that European credit markets in general will benefit and that most of the opportunities will be in the high yield market.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
The first quarter’s financial market volatility was so extreme that it forced the ECB to not only take out its ‘bazooka’ of further monetary policy measures but to fire it as well. Increasingly frenzied expectations with regards to this ECB announcement and the introduction of a Corporate Sector Purchase Programme (CSPP), whereby it would purchase non-financial investment grade corporate bonds, resulted in the bond markets rallying and credit spreads tightening significantly from their wides of mid-February (Figure 1). At the ECB’s June meeting Mario Draghi announced the official start date of the programme as well as finalising the specific details around which bonds are eligible, and which are not.
Starting out big
At the outset we believe that the ECB will look to target around €5 billion of bond purchases every month, although this could be considerably higher based on the initial pace of purchases. To put this demand into perspective it equates to around half of the net new issuance in the European corporate bond market on an annual basis currently. This is the equivalent of setting up a top tier global bond manager like Blackrock or PIMCO from scratch – demand will be significant!
While it remains to be seen exactly how many bonds the ECB is successful in purchasing, and whether or not this non-standard monetary policy achieves its desired effect, the question remains what should investors do next? Liquidity will almost certainly be impacted in both the primary and secondary markets, but the demand from the ECB will almost certainly provide strong technical support to the market. So, while we do not expect a rally in European credit as expectations of the ECB’s actions are largely priced in, nor do we expect any significant sell-off either.
We think that while the European high yield market is smaller than its American cousin, and has a lower yield, it is still worth consideration. The main reasons for its lower yield is a combination of its composition, with significantly less energy and mining exposure but more financials, and much lower expected default rates. It will also benefit from the ECB’s CSPP in two ways.
First, the ECB has stated that bonds only need to be rated investment grade by one recognised credit rating agency (CRA). Companies which have a split rating between agencies (i.e. rated high yield by one and investment grade by another) now become eligible. Unsurprisingly, BB/Ba rated credits have performed strongly over the past few months and, although unlikely to repeat this performance, still offer value (Figure 2). An expected indirect effect of the ECB’s policy results from investors having sold their bonds to the ECB reinvesting the proceeds into riskier assets. The obvious next step from investment grade is high yield bonds.
Second, while the profitability of European financials faces significant headwinds from negative interest rates and non-performing loans, they do not face the same extreme challenges as US high yield energy producers. There are several reasons to be constructive on European banks not least because, from a creditor’s perspective, their regulatory capital is improving, making them more robust and better suited to surviving their equivalent of a halving of oil prices, should a repeat occur. In the meantime their default rate is expected to remain low, especially as the ECB will be supporting their liquidity through a number of its other purchase programmes. If anything, a view on European banks in the high yield sector is more important than US energy names as the universe is comprised of approximately 20% financials, the vast majority of which are banks, whereas in the US only 13% of issuers are energy-related (Figure 3).
The hybrid allure
While yields are low in the investment grade space, ‘hybrid’ securities are an interesting investment for those investors with a higher risk appetite (Figure 4). These securities are issued by corporates and are subordinated to senior debt and have coupons which can be deferred without the issuer being deemed in default. For these reasons the CRAs give ‘equity’ credit to what is essentially a bond and hence the hybrid name – a cross between equity and debt.
The main advantage of these securities is that they often offer significant yield pick-up over senior bonds of the same issuer, although exhibit significantly more volatility (although less than the equity of the issuer), and will work as a yield enhancement play in a low yield environment. Tactically, these types of securities are trading more cheaply relative to their longer-term averages, and to a degree were left behind in the recent rally in credit.