European investment grade bonds: Key themes
Tanguy Le Saout, head of European Fixed Income at Pioneer Investments, discusses the last ECB meeting, UK gilt market, and European banks.
- ECB’s Corporate Bond Buying Programme
At its regular meeting last week, the Governing Council of the ECB released the technical parameters of the Corporate Sector Purchase Programme (“CSPP”), which was initially announced during the 10 March 2016 meeting. In short, the programme will:
- Involve bonds issued in Euro by Eurozone or non-Eurozone (but where the issuing entity is incorporated in the Euro-area) domiciled non-banking issuers,
- Target maturities from 6 months up to 30 years,
- Involve Securities a minimum rating of BBB- (using the best-of-rating methodology in case of split ratings),
- Start towards the end of Q2 2016, contributing to the monthly Euro 80bn Quantitative Easing programme already in place,
- Be made on both the primary and secondary markets, and
- Be made according to the sector and countries weightings of a market-cap based benchmark to be identified by the ECB.
The programme details are close to the market’s expectations – with the usual positive surprise that President Draghi is keen to deliver. The scope of the bonds eligible for the programme is more wide-ranging and more flexible than most expected, which in our view, should help further sustain the rally in spreads we have seen over the past few weeks. The more recent rally in higher-beta names should also continue, with eligible cross-over names (issuers with ratings split between IG and HY) likely to benefit from their inclusion in the programme.
Despite financial subordinated debt and corporate hybrids not being eligible for this programme, we expect them to continue performing after this announcement, with further search for yield and flattening of issuer spread curves a big supporting factor. Having the ECB as a “back-stop” buyer should also act as a volatility dampener on spreads. Using both routes of primary and secondary market purchases will help limit the impact on secondary market liquidity, and minimize distortions to valuations in the asset class. The absence of a specific size of the monthly purchases is not, in our view, a disappointment – but it is rather understandable given the unprecedented nature of such a programme for the ECB in the corporate bonds space, and should therefore avoid a situation of market disappointment in the event of under-delivery against any explicit targets. With regard to the scope, the inclusion of banking arms of corporate issuers (including, for instance, automakers) is in our view a very supportive move on behalf of the ECB.
- UK – Chickens Coming home to Roost
Having apparently managed to ignore the upcoming BREXIT referendum, the UK gilt market finally has had to face reality in April. Despite a significant fall in the UK currency, and the UK’s Credit Default Swaps spiking higher, UK bond yields had remained immune to rising political risk, resulting in the UK gilt market being one of the best performer’s in Q1 2016. However, April has been a different story. UK bonds initially benefitted from the early April global rally in bond yields, but then as yields reversed higher, the UK market seemed to under-perform.
It may have been caused by position unwinding as the referendum gets closer, or it may have been due to money-markets moving back to a neutral stance in terms of rate expectations over the coming three years (the market had been pricing in rate cuts). US President Obama made his position clear during his visit to the UK last week. The President was forthright about the dangers of Britain leaving the EU, which parked a testy response from London mayor Boris Johnson. Although President Obama is nearing the end of his presidency, a senior Hilary Clinton foreign policy advisor also noted that Mrs Clinton had “always valued a strong United Kingdom in a strong EU”. There are still two months to go to the referendum, and no doubt there will be further twists and turns in the campaign, but the last weekend was certainly a good one of the “REMAIN” camp. We still like to hold an underweight stance in UK gilts, both outright and against other markets.
- European Banks and Government Bond Holdings
One of the topics on the agenda for discussion at last week-end’s European Union finance ministers’ meeting in Amsterdam was an increase in the risk weights that banks apply to their sovereign bond holdings. Currently sovereign bond holdings attract a zero risk-weighting for balance sheet capital purposes, meaning banks don’t have to hold any offsetting capital against these assets. That, of course, leads to the famous “carry trade”, where banks can borrow at low or even negative rates and buy higher-yielding sovereign bonds, without having to hold any capital against those bond holdings. This has been a particularly attractive trade for peripheral European banks – Italian banks hold 12% of their assets in Italian sovereign bonds.
But it creates an uncomfortable relationship between banks and their sovereign entity, with both needing each other to remain healthy. The EU would like to break this relationship, but understandably, in the absence of a common European deposit guarantee scheme, the peripheral countries and banks are reluctant to agree. The numbers are pretty significant too – in 2014 Fitch Ratings estimated banks would need to sell €1 trillion of bonds to move from the current system to the standard limit on single exposures. If any agreement is reached, which we feel is unlikely, it will probably have a long lead-in time to implementation. But it’s another cloud on the horizon for peripheral banks and sovereigns, both of which we prefer to underweight.