What are the implications of CSPP for corporate behaviour?
The intention of any accommodative central bank intervention is to encourage more risk taking by economic agents. Historically, central banks pursued countercyclical intervention during the steepest declines in productivity to stall a deep recession and spur a recovery phase. Today, central banks’ action and accommodative policies have become second nature.
Of the G4 central banks – the Federal Reserve (Fed), Bank of Japan, ECB and (for now) the Bank of England – the ECB has been relatively muted in the use of its balance sheet for quantitative easing, and arguably the one market where asset prices have inflated the least.
CSPP – Background and progress so far
The Eurosystem started to buy non-financial corporate sector bonds under the CSPP on 8 June 2016, aiming for a more direct boost to inflation. All non-financial entities rated as investment grade (BBB and above) by at least one of the four rating agencies are eligible for purchases of up to 70% of outstanding issuance.
In the first 11 days of the programme the ECB bought €6.4 billion, representing almost 0.5% of the total eligible market size (source: Bank of America Merrill Lynch, based on Euro Non- Financials Investment Grade Corporate Bond Index, July 2016).
If continued at this pace, the CSPP would hold almost 25% of the eligible market by the planned end date of March 2017. The effect on the European corporate bond market has not gone unnoticed, as CSPP-eligible bonds have seen spread tightening of 7% greater than ineligible issues (source: Citi, 20 July 2016) .
Corporates’ historical preferences
It remains unclear how European corporates will take advantage of lower funding costs and use the historically “cheap” funding effectively. From a simplified perspective, corporations can choose to use their excess cash in one of three ways:
1. Build a cash pile,
2. Invest in capital expenditure (capex); or
3. Return the cash to shareholders via dividends or share buy-backs.
Building cash to help weather uncertainty has merits but investors may have trouble seeing their cash sitting idle after too long. This either forces re-investment, or during uncertain times, a return of cash to shareholders.
For a number of reasons the preferred cash distribution method in the US has been share buybacks with European corporates preferring dividends. There are a number of reasons for this, such as differing tax regulations, the fact that share buy-backs have been legal for almost twice as long in the US (34 vs 18 years), differing regulation on the extent to which buy-backs are allowed (25% vs 10% of market capitalisation) and the greater structural demand for income from European insurers and pension funds.
The case for enhanced return of shareholder capital
Numerous studies have been undertaken on the drivers of return of capital to investors. In particular, a recent study (Oxford Economics Research Briefing: Will ECB measures spur share buybacks?) cited depressed equity valuations, ample cash on balance sheets, reduced capex opportunities and, most importantly, cheap cost of debt as the key drivers of returning capital to investors.
As the cost of debt continues to fall and European capex spending moderates while cash piles grow, there is potential for increased cash distribution to shareholders.
The negative sentiment typically associated with dividend downgrades should dampen European corporates’ appetite for increasing their dividend policies in an otherwise uncertain economic environment. Therefore, there is notable scope for a preference for debt-fuelled buybacks at depressed equity valuations.
In the event that the CSPP becomes a more prominent vehicle in the context of the ECB’s ongoing monetary stimulus, it will likely consume a significant portion of the eligible market. This will further depress borrowing costs and increase the relative cost of equity capital. In the absence of capex opportunities, this may encourage corporates to return cash to shareholders with a preference for debt-fuelled buy-backs. While this could provide a tailwind for such companies’ equity performance, it will be accompanied a deterioration of credit fundamentals.
Ugo Montrucchio, Multi-Asset fund manager at Schroders