“I’m going to make him an offer he can’t refuse” so says Don Corleone in ‘The Godfather’. Well it’s not quite horses’ heads in beds but the bond markets have received the message loud and clear from Mario Draghi – bet against the ECB at your peril!
As the dust settles on the announced program of quantitative easing (QE) we ask ourselves what does this all mean for global corporate bond markets?
After all, according to certain market surveys leading up to the announcement, the majority of credit investors were expecting the ECB to actually include European investment grade (IG) corporate bonds in the purchase mix – now that it is clear that isn’t the case, what can we expect for investment grade spreads across the globe?
Starting with Europe, the ECB will be the dominant buyer of government bonds, European agencies, asset back securities and covered bonds until at least September 2016, leaving very little else for traditional investors in those asset classes to purchase. For example, a recent covered bond primary issuance saw the ECB (as part of their existing covered bond purchase program) make up 75% of the issue size with its order according to one of the banks that underwrote the deal. This has far reaching implications not just on the liquidity and price discovery of those markets but also on the knock on effect to other fixed income markets close by.
Indeed, we have already seen the impact of the ECB’s negative deposit rates announced in June of last year. While deposit rates across Europe had been falling for some time, which was in itself leading to good demand for investment grade corporate bond funds, the figure below shows how powerful a transmission mechanism negative deposit rates was on retail and institutional investors – causing inflows to more than double in 6 months, what had been recorded in the prior 18 months combined. This has driven substantial spread tightening in Europe, with valuations at their richest level since the financial crises in 2008.
European Fund Flows and Deposit Rates
Investors in highly rated European fixed income markets now find themselves between a rock and a hard place as they search for yield and we expect to see the demand for Euro IG credit to remain very strong while QE purchases take place, as more non-traditional investors in the asset class enter the market. This will likely lead to expensive valuations remaining that way, and for volatility in IG spreads to be suppressed in Europe.
Meanwhile on the other side of the Atlantic, US investment grade spreads have trodden a far rockier road since last June, buffeted by fears of the credit implications in the oil and gas sector, high supply of primary issuance and the knowledge that the Federal Reserve will be raising interest rates in the not so distant future. This has led to a marked difference in performance when compared to Europe over the past 6 months with spreads 37 basis points wider in the US vs. 17 tighter in Europe over the period according to Barclays Index data.
Looking back, we can see that this divergence is at extremes over recent history. Because the average maturity and credit quality differs between both the US and European indices, here we compare just spreads of 5-10yr maturity and BBB rated companies and adjust for the cost of funding between each market. Outside of the credit crises, European corporate spreads haven’t ever been so expensive relative to the US during the last 10 years.
EUR vs. USD Corporate Bond Spreads
Furthermore, in yield terms there is a substantial difference also, with the Euro Corporate index yielding just 0.93%, almost a full 200 basis points below the 2.88% on the US IG index. It is a similar story on the sterling corporate index which comfortably out yields its European counterpart at 2.78% currently.
We expect the ECB QE program will force European investors to look to the US and UK markets for the greater return opportunities on offer. Indeed, it doesn’t even have to mean taking different credit risk to what investors are used to with several European national champions such as Iberdrola, Deutsche Bank and Intesa that issue bonds both in EUR and USD, trading substantially cheaper in the US market, albeit with less liquidity.
Despite not purchasing corporate bonds the ECB’s influence on investment grade spreads in the coming months will likely be substantial. Whether in Europe or the rest of the world, taking the opposite side to Mr. Draghi could prove costly – after all it’s better to wake up with a horse’s head than sleep with the fishes!