Macaskill on markets: How to game a Draghi Put for corporate bonds
European Central Bank president Mario Draghi has been dropping further hints that he is considering unconventional measures to combat deflationary pressures in the region. This sets the stage for potential central bank buying of European corporate bonds, which in turn raises the question of whether there will be opportunities for nimble investors to game a new ‘Draghi Put’ for corporate credit.
Will Draghi let you in?
In testimony to the European Parliament in November, Draghi said that “other instruments could also be activated” to strengthen the impact of the existing purchasing programme for European sovereign and asset-backed debt.
That sounds like a crack squad of elite corporate bond traders is being held in reserve, itching to improve the supply of credit to European companies and the real economy with well-timed deals that provide some juice to the markets.
In truth, the ECB has been behaving less like a credit commando and more like a fearful conscript approaching an icy pool in basic training. It edged towards a break from precedent in the form of direct purchases of corporate bonds in July, with a surprise announcement that it had added securities issued by 13 state-linked corporate borrowers to the list of deals eligible for its purchasing programme.
But the central bank hedged this news with qualifications that suggested lawyers or veteran Bundesbank officials (or both) were trying to rein in Draghi’s determination to do “whatever it takes” to help revive growth, in the phrase he used to great effect in talking the markets out of a eurozone crisis of confidence in 2012.
The ECB acknowledged that the 13 borrowers – 12 of them infrastructure issuers, including Italy’s Enel and Austria’s OBB – differed from the government and supranational names already covered by its programme, but insisted on describing them as agencies “that are clearly public-sector entities” under its own regulatory definition.
That will change if the ECB broadens its purchasing to bonds issued by borrowers that are unequivocally private-sector corporations. A growing number of analysts expect this shift to be announced either at the next ECB meeting in December or during 2016.
Any move will be accompanied by logistical challenges and potential issues of moral hazard for the central bank. It could also lead to opportunities for investors to game a new Draghi put for corporate bonds, either by buying issues that are likely to end up on a list for ECB purchases, or by taking related exposure such as selling default swap protection on companies that may get a boost from a programme.
The Volkswagen emissions scandal in September and sharp related widening in the spreads of its bonds provided a stark warning of the challenges that could be faced by the ECB, as Euromoney pointed out at the time.
It is difficult to envisage a way to buy corporate bonds that would avoid the risk of potential embarrassment for the ECB in the event of a commercial scandal or other form of idiosyncratic risk.
Even a logical, transparent approach could foster market distortions.
The obvious way to start buying bonds would be to identify a sub-section of the iBoxx corporate bond index that is the benchmark for European borrowers as an eligible pool for purchases. That currently comprises around 1,700 bonds for a notional total of €1.45 trillion of debt, but after financial borrowers and issuers from outside the eurozone are stripped out the pool contracts to around 740 bonds with a notional size of roughly €563 billion.
A move by the ECB to buy up to 10% of this available paper, or around €50 billion of bonds, could exert immediate downward pressure on the spreads of eligible deals and effectively lower the borrowing costs of a select group of corporations.
There would be unavoidable favouritism in this approach, with some companies benefiting disproportionately simply because of their borrowing habits. This could boost certain companies relative to others within sectors and reward large companies with active debt management programmes more than smaller firms that do not habitually issue euro-denominated corporate bonds.
French supermarket Carrefour would presumably be on a list of debt issuers eligible for ECB purchases, for example. Tesco, which is based outside the eurozone in the UK, and Aldi, which is based in Germany but does not tap the public bond markets, would not be on a likely ECB list.
German pharmaceutical giant Bayer’s debt would probably be eligible for purchase, while bonds issued by its US competitor Pfizer would not.
Pfizer and other big US firms could still benefit if ECB corporate bond buying was introduced to complement quantitative easing, however. Euro-denominated bond sales by US borrowers have surged in 2015, collectively accounting for 25% of total investment-grade issuance in the currency. That trend can be expected to continue in 2016 if Federal Reserve and ECB policies diverge and would be encouraged by any central bank buying plan for corporate bonds on the secondary markets, even if deals from US borrowers are not eligible for direct purchases.
The ECB could also develop an unwelcome reputation as a proxy lender of last resort, or at least a debt spread anchor for troubled corporate borrowers.
Volkswagen, which is currently battling to restore its reputation and fund coming regulatory and litigation costs that are impossible to quantify in advance, would have an ally in its negotiations with creditors if the ECB were known to be a buyer of its corporate bonds, for example.
ECB bond buying could also have unpredictable effects on the basis between bonds and related markets such as loans or credit derivatives. Volkswagen reportedly held discussions with banks about a credit line of around €20 billion in November and would probably have welcomed signals from the bond market that indicated that its borrowing costs had come down from emissions scandal-related highs as it held the talks.
The banks involved might have been tempted by a Draghi put for certain corporate bonds to ease up on hedging that they would normally undertake via credit default swap protection purchases on Volkswagen as they committed to lend money to a firm with an uncertain future. This is arguably straying close to proprietary risk-taking of the sort that regulators including the ECB have been trying to curb in recent years. Basis trades between corporate bonds and default swaps were one of the sources of dealing losses suffered by banks in the 2008 credit crisis, and while standalone proprietary dealing desks have been cut by banks, there is still plenty of basis risk to be managed. ECB corporate bond buying – or even an announcement that purchases are under consideration – could also hurt secondary market liquidity, which has already diminished, in part as a side effect of the reduction in bank proprietary trading.
The Federal Reserve in November announced that US bond dealers had aggregate negative holdings of corporate bonds for the first time. This news came as the persistent negative spread of US interest rate swaps to treasury yields also drew attention, as it is both unusual and counter-intuitive, given that interest rate swap spreads include a bank credit component that would normally involve a spread over the main government bond benchmark.
While these trends may not portend the approach of financial market end times, as some commentators have suggested, they are certainly very odd and reflect unexpected consequences of the changing regulatory backdrop for dealers.
Any move by the ECB to insert itself into European corporate bond price transmission could bring similarly unpredictable effects to another corner of the markets.