Fixed Income Focus - Central bank distortion

After amassing vast quantities of government bonds, central banks have now added corporate bonds to their monetary menu and credit investors are assessing the consequences

(PresseBox) (London, ) Before we discuss the details, it’s important to take a step back and recognise the extreme world we live in. After many years of extraordinary monetary policy, an enormous quantity of government debt now sits on central bank balance sheets, with bonds worth trillions of dollars trading with a negative yield. But their recent decision to buy corporate bonds takes policy to another level – directly setting the cost of debt for companies.

This could make sense if capital markets were broken, trading at high yields and unable to determine a fair cost for borrowers and investors. But as Figure 1 highlights, corporate bond yields are currently at historically low levels and sound companies have no difficulty raising money. Instead, an intervention at such levels could have a detrimental impact as true investors recoil from yields that do not adequately compensate for risk. We do not believe that such financial repression creates an environment that encourages risk taking, business investment decisions and, ultimately, economic growth – in fact, we suspect quite the reverse.

We did not anticipate that central banks would take such a radical step and our active portfolios therefore underperformed the benchmark during this period. We have subsequently added exposure to bonds that are eligible for the programme. That said, in such manipulated times we believe it is crucial to stick to our long-term investment philosophy, focusing on true fundamental opportunities. As we saw in the CDO and structured credit craze ten years ago, simply chasing yield in a distorted market is unlikely to end well. Indeed, there are many examples of markets that are perceived as stable that suddenly dislocate and sweep away unprepared investors. As Russell Napier eloquently stated "the most dangerous thing in finance is the thing that never moves – until it moves".

CORPORATE BOND BUYING

Back in March, the European Central Bank (ECB) announced that it would add corporate bonds to its asset purchase programme. Initially, it wasn’t made clear what volume would be involved, but since they started buying in June the rate has been about €1.7bn a week. The plan was to run until the end of March 2017, by which time we estimate the ECB will have bought about €72bn of debt.

Then in August, the Bank of England (BoE) announced its intention to buy corporate bonds, starting in the middle of September. The amount involved is up to £10bn for an initial period of 18 months, which works out at a rate of about £130m a week.

Both banks are only buying investment grade bonds denominated in the local currency, and both are avoiding bank debt. But other details are a little different, with the ECB able to buy new issues, while the BoE is restricted to the secondary market. The ECB is buying European companies, but the BoE will buy bonds from any company that makes a material contribution to economic activity in the UK.

Their intention, however, appears to be the same. Even though yields were already at very low levels, central banks are hoping to reduce risk premia further, stimulate more issuance and perhaps also drive associated asset prices higher as displaced investors look for alternatives. Notably, the BoE stated in its August policy summary that "purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases". Even if such confidence proves misplaced, this statement implies that central bankers won’t be easily persuaded to change course for the foreseeable future.

THE MARKET IMPACT SO FAR

Figure 2 shows our best estimate of the volume of corporate bonds that are to be purchased in each programme, as well as the size of eligible bonds as a proportion of the relevant corporate bond indices.

Of course, it’s quite possible that the programmes will vary in the coming months, but the initial market impact has already been significant. The most notable impact has unsurprisingly been on corporate bonds that are directly targeted by the programmes. Figure 3 shows the trajectory of credit risk premia (spreads between corporate and government bond yields), highlighting that all European credit performed well following the announcement of the ECB’s bond buying programme in March. But there was clear outperformance of bonds eligible for the programme. Similarly, the BoE’s announcement in August saw sterling credit spreads tightening across the board, but eligible names outperformed the broader market once again.

FUTURE MARKET IMPLICATIONS

It seems likely that the euro and sterling credit markets will remain distorted by central bank purchases for some time to come. Investors may take comfort from this support in the short term, particularly if broader credit markets suffer a difficult period. However, this must be weighed up against fundamental value. Even before central banks started to buy corporate bonds, we did not think that credit spreads were cheap versus the risks associated with the asset class (such as the potential for credit deterioration). Now central bank buying is likely to keep valuations further away from fair value. This is important because even though a bond is eligible for the programme, if it is downgraded to sub-investment grade or ultimately defaults, investors could still be faced with steep losses.

We therefore believe that investors will look to switch to less distorted corporate bonds. As shown in Figure 3, there are bonds within the euro and sterling investment grade indices that are ineligible for the programmes that provide a spread pick-up versus eligible bonds. But there are other credit markets, notably the US dollar corporate bond market, that offer an even greater opportunity. The cost and inconvenience of currency and interest rate hedging must be taken into account, but relative valuations can more than compensate for this. Our ability to invest globally within euro and sterling-benchmarked portfolios is therefore very important.

At the margin, we’d also expect to see investors move down the risk spectrum into sub-investment grade in order to pick up extra yield. However, it is crucial to be adequately compensated for the additional credit risk, particularly in less liquid asset classes.

From an issuer perspective, we have already seen companies react to tighter euro and sterling credit spreads by issuing new bonds that they might have otherwise issued in other markets. So far, this has been beneficial for investors such as us who have been able to buy new bonds while credit rallies. But once spreads reach levels that investors baulk at from a fundamental perspective, the situation could become more difficult.

WHAT NEXT FROM CENTRAL BANKS?

Central banks face a dilemma. Their purchases are currently supporting credit valuations, but this may be more than offset by investors leaving the asset class in search of better returns. The ECB and the BoE could then face the unpalatable prospect of allowing the euro and sterling credit markets to underperform other markets until such flows cease, or having to step up their purchases of corporate bonds. We think central banks could end up being sucked in ever deeper, with credit valuations increasingly influenced by their purchases rather than fundamental risk.

In Japan, distortionary policies from the Bank of Japan (BoJ) have forced government bond yields deep into negative territory. But investors are understandably reluctant to purchase corporate bonds with a negative yield, so credit spreads have actually widened as a result. Issuance has been slow because companies do not want to pay this extra risk premium and the BoJ is now under pressure to step in to drive corporate bond yields into negative territory. The situation is in danger of becoming absurd.

Unfortunately, therefore, it is clear that monetary madness is here to stay for the foreseeable future. We need to be very aware of its impact when actively managing the risks across our credit portfolios. But to repeat what we have already said, and despite such distortions, we believe it is crucial to stick to our long-term investment philosophy. This means focusing on true fundamental opportunities and avoiding assets that do not compensate for their credit risk.

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