In the spring of 2016, traders at Germany’s central bank sat down with investment bank advisers in Frankfurt to discuss a once unthinkable project: how to build a multibillion-euro corporate-debt fund.
Fast forward 18 months and the European Central Bank has changed the face of the euro corporate-debt market, having bought almost EUR120 billion ($141 billion) of these securities. Financing costs for companies have fallen to the point where junk-rated firms can borrow at similar yields to U.S. government debt, prompting concerns it is fueling a bubble.
Few investors think a bubble will burst Thursday, when the ECB is widely expected to announce plans to trim its asset purchases of EUR60 billion a month. But the fact that corporate bonds now trade around levels not seen since before the financial crisis makes many uneasy about the market’s long-term trajectory.
“When the ECB steps back, it increases vulnerability in the market,” said Hans Lorenzen, head of European credit strategy at Citigroup Inc, who is recommending clients dial down their exposure to credit.
He calculates that eurozone corporate-bond yields need only rise around 0.2 percentage point to wipe out a year’s worth of returns for credit investors. “Your sensitivity to losses is very, very high,” he added, because bonds yields are so low.
Global central banks for years bought trillions of dollars’ worth of government debt under so-called quantitative-easing programs, or QE, in an effort to lift inflation. That boosted corporate bonds, whose prices are heavily influenced by government debt.
But never before had a central bank made such large-scale purchases in the corporate-credit market, where debt defaults are more common and trading is often patchy. That changed in March 2016 when the ECB announced it would start buying investment-grade euro corporate debt as part of its asset purchases from June of that year to boost the effectiveness of the EUR2.3 trillion program.
The Bank of Finland, one of six regional central banks tasked with carrying out the purchases, took a leading role in preparations, having already been buying corporate bonds to invest its own reserves for over a decade.
“We had the information and market contacts we could share”, said Elisa Newby, head of market operations at the Bank of Finland.
Others staffed up. Germany’s Bundesbank has doubled its trading team to 10 people over the past five years as a result of the various ECB programs, according to people familiar with the matter.
It was also a learning curve for investment banks that underwrite and sell corporate debt.
The Bundesbank, for instance, doesn’t attend roadshows where companies talk to investors ahead of new bond deals, according to people familiar with the matter, or discuss pricing. Instead, investment bankers would send a spreadsheet with bond details to ensure they were eligible for the program along with pricing information that would form the basis for their decision, those people said.
“We won’t buy at any price. But then again, we do have quantity targets, ” Ms. Newby said.
Investors say the central bank purchases have generally progressed smoothly. But they have also drawn criticism from some quarters.
The Bundesbank — the largest buyer in the overall QE program, as well as a stern critic — warned in a July report that buying company debt opens the ECB to losses and may distort the market.
Last year, Ms. Newby got a call from a concerned citizen wondering why the Bank of Finland had bought the debt of Ryanair Holdings PLC after having a “dissatisfying experience” with the Irish airline.
For its part, the ECB has noted the positive effects in lowering companies’ financing costs, including those that don’t rely on bond markets for their funding.
Up until the end of September, the ECB had bought EUR115 billion in corporate debt, more than the EUR103 billion of net new eligible bonds issued over that period, according to Citigroup, partly because it has bought heavily in the secondary market. But while the presence of a huge new buyer hasn’t spurred a torrent of additional debt sales, it has had a marked impact on prices.
One of the clearest signs of high valuations: over a quarter of euro investment-grade corporate bonds have a negative yield, according to Tradeweb, compared with virtually none a few years ago.
As the ECB bought high-grade debt, investors pushed into riskier securities in search of returns. The extra yield investors demand to hold BB-rated European corporate bonds — the highest-rated securities the ECB can’t buy — over haven government debt is at its thinnest level since before the financial crisis, according to Bloomberg Barclays bond indexes.
“No doubt the environment has enabled slightly smaller, probably slightly more racy… companies to have good access to the market,” said Edward Farley, head of European corporate bonds at PGIM Fixed Income.
The ECB’s buying has also watered down some traditional creditor protections. Its rules state it can’t buy bonds with so-called step-up clauses, which automatically jack up debt interest payments if a company is downgraded by ratings firms. There has been EUR14.5 billion of such securities sold this year, a decline of 24% from the same period in 2015 before the ECB’s corporate purchases started, according to Dealogic.
All this has prompted some credit investors to take precautions. Colin Purdie, head of investment-grade credit at Aviva Investors, prefers to own bank bonds — which the ECB doesn’t buy — over utility bonds that it has bought and could be more vulnerable to it scaling back.
“You’re going to see more direct impact on securities the ECB has been buying,” he said.
Strategists at J.P. Morgan Chase & Co. have recommended clients take measures to protect their corporate-bond portfolios ahead of the ECB meeting. Their warning: a larger-than-expected reduction in purchases could jolt markets, while there is also a “small risk” the ECB’s buying stops altogether at the end of the year.
“We think that the risks are skewed to the downside,” the strategists wrote in a recent note.
Source: Dow Jones